Getting a Double Penalty Benefit or Getting to the Right Result

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

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

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

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

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

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

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

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

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

 

Prisoners Filing Fraudulent Returns and the Efforts to Detect It

On July 20, 2017, the Treasury Inspector General for Tax Administration (TIGTA) issued its third report in the past several years on the topic of tax fraud perpetrated by prisoners and the efforts to detect and stop it.  As with most TIGTA reports this one bears the catchy title “Actions Need to be Taken to Ensure Compliance with Prisoner Reporting Requirements and Improve Identification of Prisoner Returns.”  While TIGTA found a number of items the IRS needed to improve because that’s its job, I found that the IRS had made significant improvements in this area due to increased effort and legislative assistance.  I last wrote about this issue on April 24, 2015 following the last TIGTA report.

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Prisoners have a reputation for using the tax system to get easy money.  The increase in the use of refundable credits put a target on the back of the IRS as a place to pick up money simply by filing a tax return.  Since tax returns can be filed from prison, using the tax system to gain access to money makes sense for prisoners.  When Congress created the first time homebuyer credit and the refundable adoption credit, it created very attractive targets for the type of fraudulent activity by prisoners.

In this report, TIGTA continues to find problems with the way the IRS administers the program for catching prisoners but the data also shows that the IRS has made significant strides using the relatively new legislation as well as its computers.  The process of seeking prisoner fraud looks very much like the other processes the IRS uses to detect mistakes in individual tax returns.  It relies heavily on matching information with computers rather than people and applying filters.  The ability to tackle the problem without devoting much people power allows the IRS to succeed here in a time of reduced resources.  While this program does not bring in revenue, the ability to keep improper refunds from going out the door is at least as important as putting effort into bringing in money.

One of the legislative changes requires prisons to provide the IRS with the Social Security Numbers of inmates.  The IRS then puts a prisoner indicator on the account of that SSN.  If someone is in prison, we should not expect that person to have significant income, though of course exceptions exist, and we should not expect that person to buy a home, adopt a child or engage in other activities that might trigger a refundable credit.  Having the information from the prisons, allows the IRS to do some immediate filtering that can catch improper claims.

Dealing with prisoner fraud also implicates the broader area of identity theft.  The IRS appears to have made significant strides in attacking ID theft in the past two years and that success has an impact on prisoner fraud since fraudulent returns filed by prisoners will more often than not involve the use of stolen or misused identification.

There is more than one program underway to stop prisoner refund fraud.  In addition to getting the SSNs of prisoners and loading it into the IRS database, prisons are now more carefully monitoring prisoner communication looking for tax fraud.  When a prison identifies a communication as one which might involve tax fraud, it notifies the IRS through the “Blue Bag Program.”  While the amount of correspondence sent to the IRS using this program in 2016 was slightly under 1,000, the existence of the program must serve as a deterrent.  This program would seem to play to a strong suit of prisons the way data matching plays to a strong suit of the IRS.

The prison program did not seem to work as well as one might hope in addressing the cases in which the IRS detects fraud by a prisoner.  The report indicates that the IRS might stop the fraud but little is done to punish the prisoner who engaged in the fraud even though the prisoner is known.  The IRS is not going to be able to prosecute prisoners unless they engage in a fairly wide ranging fraudulent effort just because of the limitations on its resources.  My impression from the report was that when the IRS provided information to the prisons about specific tax fraud activity but that information did not necessarily result in parole denial or other actions that could occur without criminal tax prosecution.  While the report did not discuss this in depth, it would seem that tailoring disclosure laws to allow the IRS to provide prisons with detailed information about an incidence of tax fraud and making that information a part of probation denial and other punishments within prison system without requiring criminal tax prosecution would be a way to strongly deter prisoner fraud for prisoners with hope of release or of the ability to use computers or other forms of communication.

TIGTA found that the IRS had not created a master list of all prisons.  Most of the prisons the IRS seemed not to be getting information from were part of the state and local system.  I would be interested in an analysis of which prisons or which types of prisons are most likely to generate tax fraud.  It would seem to state prisons incarcerating individuals for crimes of violence would be much less likely than federal prisons with more white collar crime and the knowledge base for creating the type of scheme necessary for refund fraud but my thinking about this could be entirely wrong.  Still, a profile of the likely prisoner to commit tax fraud would seem like something useful to create and to target efforts on those prisons or those prisoners where the likely criminals reside.

Since few tax practitioners represent incarcerated individuals, this report may provide little practical information.  I see it as a success story for IRS and Congress at a time when there are not enough success stories about legislative or administrative efforts to fix a problem.  Maybe lessons can be learned from the efforts to stop prisoner fraud and applied to the tax gap generally.  We know where the big holes are.

 

Two Years Later: Form 1042-S Frozen Refunds

We welcome back a former student of Les and mine, Sonya Miller, who is now an Assistant Professor-in-Residence at the William S. Boyd School of Law, University of Nevada, Las Vegas.  She also directs the brand new Russell M. Rosenblum Tax Clinic Program serving low income taxpayers in the Las Vegas area.  Sonya wrote one of the most popular posts we have had at PT about the IRS program directed at nonresidents and their requests for refunds.  In today’s post she updates us on the program.  The program seems to be a situation in which someone saw abuse and the IRS chose a blunt an instrument to combat that abuse.  In doing so it caught a lot of people in its net that did not belong there, spent more of its own resources than necessary and paid out several million dollars in interest.  The program may have had successes that we do not chronicle because we do not know about them.  Perhaps we will learn about them in some future TIGTA audit.  Keith

Around this time in 2015, while I was directing the Federal Tax Clinic at the University of South Dakota School of Law, it came to the clinic’s attention that the Service was freezing refunds from Form 1042-S withholding for nonresident students at the University. The clinic and I wrote about the issue in Procedurally Taxing here. At that time, dealing with the Service to represent these taxpayers was extremely frustrating; it was like talking to a brick wall. Repeated phone calls to the practitioner priority line yielded virtually no information. We contacted the Taxpayer Advocate Service (TAS) for assistance and still it was slow going. This is likely because, as the National Taxpayer Advocate (NTA) noted in her Fiscal Year 2016 Objectives Report to Congress, the Service directed taxpayers to contact the Taxpayer Advocate Service (TAS) for assistance but had not provided TAS with any specific procedures or protocols that could be followed to assist these taxpayers. Indeed, in her Fiscal Year 2017 Objectives Report to Congress, the NTA notes that the Service was no more forthcoming with TAS than it was with other third parties: “The National Taxpayer Advocate and her staff raised concerns about the matching program and the student Form 1042-S issues. These concerns, however, were repeatedly dismissed by the IRS officials charged with operating the program.” On behalf of affected taxpayers, TAS issued mass Operation Assistance Requests and developed Taxpayer Assistant Orders.

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The NTA further noted in her report the unfair burden the Service placed on compliant nonresident taxpayers in an attempt to catch a few bad actors, while leaving compliant taxpayers with virtually no recourse for proving that they were entitled to the frozen refunds. Indeed, this was our experience at the South Dakota clinic. Early on in representing our student taxpayers, we contacted the University’s comptroller and received proof that the University had in fact withheld taxes from the students and had turned the money over to the Service. Still, the Service refused to release the refunds. It took so long to get the refunds released that I cannot be sure that it was our representation of the students that caused the Service to finally release the refunds. By the time the students contacted us, the refunds from their 2014 Forms 1040NR had been frozen for five months or more. Some of the students waited over a year to receive their refunds.

To be fair to the Service, it was trying to prevent fraud. Even so, no such burden exists for domestic taxpayers whose withholding agents fail to turn over withholdings. When an employer fails to turn over payroll tax to the Service, domestic taxpayers are still entitled to receive a refund from any over withheld taxes. Moreover, the Service’s means (trying to match the information in each and every Form 1042-S reported by withholding agents to each and every Form 1040NR or 1040NR-EZ filed by taxpayers) to reach the end of preventing fraud, was a blunder, which the Service recognizes in hindsight. However, the Service does attempt to place more of the burden on withholding agents by disincentivizing bad behavior. Withholding agents face hefty penalties if they fail to meet the requirement to file Forms 1042-S. They also face penalties for failing to furnish correct Forms 1042-S to recipients. Failing to ensure that Forms 1042-S reported to the Service exactly match the forms provided to the taxpayer is one common mistake that withholding agents make. Treasury Regulation 1.1461-1(h) lists the code sections for all of the penalties to which withholding agents may be subject.

However, notwithstanding its limited resources, as the NTA highlights, the Service could always do more to use its resources effectively.  In her Fiscal Year 2017 Report to Congress, the NTA states that the Service’s verification process for refunds based on Forms 1042-S “has not only been costly for taxpayers, but for the IRS, which has estimated that an extension of the freezes through early 2016 would generate an interest expense of over $4 million.” She further states that the Service could have maximized its resources had it “simply used technology already developed and pre-tested in the domestic withholding context” rather than using a separate, systemic matching program.

In an effort to “try harder and do better,” it has been reported (full text on file with the author) that the Service will no longer systemically freeze all refunds based on Forms 1042-S and will manually review all frozen refunds. The service describes its matching program in IRM 21.8.1.11.14.2. Unfortunately, we the people are not privy to most of the information in this IRM—the Service has heavily redacted it. It seems that the Service redacts information for fear that people will use the information to game the system. So, if I had to hazard a guess, in line with the de minimis exception in IRS Notice 2015-10, the redacted information probably says something about which refunds will be systemically frozen and which will not and that there’s a threshold amount to make this decision. Nevertheless, in IRM 21.8.1.11.14.3, the Service does set out what the matching program looks for in determining a good match. Where refunds are frozen, the freeze will systemically release after a little over five months. Also, IRM 21.8.1.1.13, informs IRS employees that nonresident taxpayers have rights under the Taxpayer Bill of Rights, which means that the Service cannot just keep nonresident taxpayers in the dark regarding the status of their refund claims. Change has been somewhat slow but the Service has taken responsibility for its transgressions and appears to be moving in the right direction.

 

 

 

 

 

 

Starr v US and The Power to Confer Discretionary Treaty Benefits: Part 1

It is not often that the courts wrestle with the application of discretionary treaty provisions. Earlier this month, in Starr International v US , a DC federal district court found that the Competent Authority did not act arbitrarily or capriciously in denying discretionary relief under the U.S.-Swiss Treaty. In today’s post, I will  discuss the jurisdictional battle that led to last week’s opinion. I will follow up in Part 2 with a discussion as to the court’s application of the APA to the treaty claims.

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In 2015, in District Court Hands IRS Loss in its Bid to Exclude Discretionary Treaty Benefits From Judicial Review I discussed the fight between The Starr International Group and the IRS over Starr’s efforts to get the benefits of discretionary treaty relief that would have reduced US withholding on AIG dividends. Much of the post discussed the government’s unsuccessful efforts to convince the court that the decision was not subject to court review. That opinion, and my post, discusses why there is a strong presumption against unfettered agency discretion.

Following that setback, the government asked the court to reconsider. In a 2016 opinion, the government did get a victory, of sorts. Despite reaffirming its earlier conclusion about the court’s power to review the IRS’s decision to not grant discretionary treaty relief, the District Court held that separation of powers principles meant that it could not order a monetary refund for Starr even if it felt that the US competent authority improperly applied that the anti-treaty shopping provisions of the US –Swiss tax treaty.

The 2016 opinion explored the  limits of the court’s powers. In so doing, it discusses how in treaties there is a consultation process between the contracting states following one state’s Competent Authority determination that a party is entitled to discretionary treaty relief.  That consultation is an executive branch function. As such, the 2016 opinion concludes that the courts are unable  to mandate that a party is entitled to receive a refund based on a claim that there was an improper application of a discretionary tax treaty provision. On that point, the opinion was clear:

To determine that Starr is entitled to a certain sum of benefits, the Court would be forced to step into the shoes of the IRS and its Swiss counterparts and effectively preordain the outcome of any consultation between the two. This a court may not do.

Yet in that 2016 development the district court concluded that Starr could bring a claim under the APA seeking to set aside the U.S Competent Authority’s determination and that if Starr “prevailed on that claim, [it] would be entitled … to have the matter remanded to the U.S. Competent Authority for further action” consistent with the Court’s opinion.

The 2016 opinion nicely summarizes how the APA provided jurisdiction over Starr’s dispute:

The APA makes “final agency action for which there is no other adequate remedy in a court … subject to judicial review.” 5 U.S.C. § 704. The government concedes that the Competent Authority’s decision constitutes final agency action. And if the Court were to hold that Starr could not challenge the decision through a claim brought under the tax-refund statute, then no other adequate remedy would exist, and review under the APA would be proper. Cf. Cohen v. United States, 650 F.3d 717, 736 [108 AFTR 2d 2011-5046] (D.C. Cir. 2011) (en banc) (directing the district court to consider the merits of an APA claim against the IRS when plaintiffs had “no other adequate remedy at law”).

In allowing Starr to bring a claim under the APA, the 2016 opinion acknowledged that Starr’s ultimate goal was a refund, not just an academic finding that the Competent Authority acted improperly. Yet, the opinion paved the way for the Starr Company to amend its complaint to bring the APA claims and suggested that such a finding might in fact lead to a refund (or at least a consultation about a refund):

As the Court has explained, however, monetary relief of any sort is unavailable to Starr without improper judicial intervention into the consultation process….

The Court declines to assume, however, that Starr would forgo an opportunity simply to have the Competent Authority’s decision set aside as arbitrary, capricious, or an abuse of discretion. Indeed, as the government recognizes, remanding to the agency for further consideration is the norm when a court sets aside an agency’s action. And this relief is not illusory. Regardless of whether the Court possesses the authority to order the IRS to engage in consultation, counsel for the IRS has represented—and the Court would fully expect—that the IRS would not decline to consult with the Swiss in the event that the Court found that the IRS abused its discretion and remanded to the IRS, and the IRS otherwise preliminarily determined that Starr qualified for treaty benefits. Hr’g Tr., ECF No. 34, 42:8-18. The Court thus will not deprive Starr of the opportunity to seek this form of relief under the APA. It will grant Starr leave to amend its complaint to bring such a claim.

Starr dutifully amended its complaint to include APA claims. This led the district court in an opinion earlier this month to apply the APA to the Competent Authority’s decision to deny treat benefits. In Part 2 of this post, I will discuss the court’s analysis as to why under the APA the Competent Authority did not act improperly in finding that the discretionary treaty benefits did not apply to reduce withholding on the AIG dividends.

 

 

District Court Denies 6511(h) Financial Disability Claim

We have covered several cases in which the taxpayer sought to hold open the statute of limitations based on financial disability here, here, here, and here.  In Estate of Kirsch v. United States, the taxpayer’s estate loses, which is the norm for these cases, but does so with slightly different facts than the usual case.

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Ms. Kirsch passed away on September 16, 2016.  Her estate brought this action seeking to recover a refund of an overpayment for her 2008 return.  She did not file the 2008 return until June 5, 2015.  Her estate argued that the delay in filing was due to financial disability.  When she filed her 2008 return seeking a refund, she knew that she had missed the time for filing a refund absent the suspension caused by the financial disability provisions.  So, she submitted with the return two statements, one from her doctor and the other from her son.

The doctor’s statement provided:

Florence W. Kirsch is a patient known to me.

  1. [Ms.] Kirsch has been diagnosed with a cognitive mental impairment;
  2. It is my medical opinion that in addition to issues in remembering to take certain medications, her mental impairment has prevented [Ms.] Kirsch from managing certain aspects of her financial affairs;
  3. It is my medical opinion that the mental impairment has lasted for a continuous period of not less than twelve months and will continue to last indefinitely;
  4. While first diagnosed on January 3, 2012, [Ms.] Kirsch first began reporting issues with her memory in 2007. Given the progressive nature of cognitive mental impairments, [Ms.] Kirsch would have begun to experience adverse effects of her mental impairment first in 2007 and it became progressively worse.

 

The statement from her son, which it what makes this case somewhat unusual, involves a durable power of attorney granted to him.  In 2003, Ms. Kirsch created a durable power of attorney naming her husband as her agent and her son, Ken Kirsch, as the successor agent.  Mr. Kirsch, the husband, passed away on March 28, 2009, before the 2008 return was due.  Ken Kirsch did not exercise his authority under the power immediately.  He said in his statement that he lives on the West Coast, some distance from his mother in Massachusetts and did not realize that his assistance was required until about the time the refund claim was filed when her symptoms became more pronounced.

The statute requires that the taxpayer seeking to suspend the normal three year period for filing a refund claim show financial disability and defines that as someone who “is unable to manage [her] financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.”    You cannot be considered financially disabled unless “proof of the existence thereof is furnished in such form and manner as the secretary may require.”  The IRS has not gotten around to writing regulations on this issue yet but it issued Rev. Proc. 99-21 which sets out the requirements regarding a statement from a physician’s medical opinion.  The Rev. Proc. also sets out the requirement of a statement from the claimant that no person was authorized to act on the individual’s behalf during the period of impairment described in the doctor’s statement.  The second requirement exists because the statute also provides that a person is not financially disabled if “any other person is authorized to act on behalf of such individual in financial matters.”

The IRS argued that no suspension of the statute should occur in this case based on the inadequacy of the doctor’s statement and the existence of the durable power of attorney to the son.  The court agreed with both points.

The problem with the doctor’s statement her is the uncertainty of the starting point.  The statement says Mrs. Kirsch “would have begun” experiencing the effect of her mental impairment in 2007 but does not make a clear statement that in 2007 she could not manage her financial affairs.  The problem may stem in part from the doctor’s uncertainty about the progression of her illness.  The situation here mirrors other situations in which taxpayers have tried to claim financial disability.  The creation of the durable power of attorney several years before might suggest her family members saw a problem but, on the other hand, the delay in action by her son suggestions whatever impairment existed, he did not see it from afar.  The family tried to fix the problem by submitting another statement from the doctor.  The court acknowledged a willingness to receive a supplement statement citing Bowman v. Internal Revenue Serv., No. CIV-S-09-0167 MCE GGH PS, 2010 WL 178094 (E.D. Cal. Apr. 30, 2010); however, it found that the supplemental statement did not cure the defect because it still did not say exactly when she became financially disabled.  The physician continues to discuss her abilities based on an examination in 2012 where the issues existed and her statements that they began in 2007 but does not describe when the impairment crossed the line into financial disability.  Doing so would be a hard task for almost any physician.  The statement just talks about her cognitive abilities becoming worse over time.

Additionally, the Court finds that even if the doctor’s statement had contained satisfactory language, it still would not have found financial disability because of the power of attorney given to the son to assist her.  His letter states that he was authorized to assist her.  The son argued that the durable power of attorney did not become effective under Massachusetts law until “the designees became aware that they had such authorization.”  The Court holds that even if he is right about Massachusetts law he was authorized to act on his mom’s behalf during the time periods referenced in the doctor’s letter.  As such, the estate cannot meet the criteria in the statute.

I agree with the Court that the doctor’s letter leaves something to be desired in terms of clarity about exactly when Mrs. Kirsch became impaired.  The statute creates a very difficult task for a doctor how sees a patient only infrequently.  The doctor knows when the patient can no longer function with financial affairs (or can make a reasonably educated opinion based on observation) and knows that the inability did not turn on like a light switch but does not know exactly when the line was crossed.  It would seem that where the doctor makes a statement like the one here that other evidence should be allowed to more precisely pinpoint the timing when the line was crossed or a non-treating professional should be allowed to take the doctor’s opinion coupled with the other evidence and give a professional opinion.  Stating precisely when someone can no longer handle their financial affairs would not have been the goal of the doctor at the time of treatment and hindsight will not always allow for precision in this type of diagnosis.

The problem with the power of attorney exists whenever the person with the power is remote or not paying careful attention.  Not many children want to step in and declare their parent incompetent with financial affairs.  It is nice to create the power before the parent loses the capacity to grant it; however, deciding to exercise it requires a different calculus.  Where, as here, the son was remote it becomes even more difficult.  He was not seeing his mom on a regular basis apparently and would have had difficulty recognizing when her actions crossed over the line.  I see this with my own dad.  My sisters and I are in constant contact with him.  While at 91 his cognitive abilities are not what they once were, he is still quite financially able.  We see little things but we are watching closely.  Someone who is remote will have a very difficult time until a significant event occurs.

No one is arguing that the refund does not belong to the estate but for the statute of limitations on claiming it.  While the finality of a statute of limitation provides benefits, I question whether the benefits are great enough in these situations.  Do we have to make it so hard to recover monies lost because of cognitive decline?  I do not think we do.  I think we should be more compassionate.  This money is an overpayment of tax.  Someone who has spent a lifetime complying with the tax statutes should get a break when compliance becomes difficult because of cognitive decline.  We should err on the side of returning the money.

District Court Grounds NetJets’ Refund Suit

NetJets Large Aircraft v US, a recent case out of the Southen District of Ohio, [free link not available], illustrates some of the nooks and crannies that taxpayers must navigate in refund suits. Being right on the merits is not enough. Filing a timely claim for refund is a jurisdictional requirement, even when the circumstances are clear that the government knows that a taxpayer wants its money back. Most of the times when there is a dispute about timeliness of a claim the issue revolves around a taxpayer filing a claim too late. Sometimes, as in this case, a claim for refund can also be too early.

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IRS assessed NetJets and related entities air transportation excise taxes on a variety of fees that the fractional jet company collected from its customers. For a court to have jurisdiction over a refund suit, taxpayers must under the Flora rule fully pay the tax, file a refund claim, and if the Service denies the claim, file a refund suit in federal court. As a divisible tax, under Flora, NetJets only needed pay the amount of excise tax due on an individual transaction for each tax quarter at issue to gain standing to challenge the entirety of the assessment.

NetJets payed a representative amount of tax, and then filed a claim for refund on the amounts it paid.(As to whether an amount is considered representative to meet the Flora divisible payment exception see an earlier two-part guest post by Rachael Rubenstien here ). After the Service denied the claim, it filed a suit seeking 1) a refund of the amounts it paid and 2) an abatement of the unpaid amounts the IRS had assessed for other transactions that IRS felt were subject to the excise tax.

Here is where it got tricky for NetJets.

During the pendency of the suit, IRS applied overpayments from other periods to the unpaid assessments that were at issue in the refund suit.  NetJets won on the merits in the refund suit and then filed a motion to make sure that the district court’s final judgment included an order that directed the Service to pay back the tax that were originally listed in the complaint as well as the overpayments that the IRS had applied during the pendency of the suit.

For support for its motion, NetJets relied in part on Fed R Civ Proc 54(c), which states that ‘[e]very . . . final judgment [other than a default judgment] should grant the relief to which each party is entitled, even if the party has not demanded that relief in its pleadings.'”

The Service disagreed, and in opposing the motion argued that the US had not waived sovereign immunity with respect to the overpayments it had applied to the unpaid assessments during the pendency of the refund suit. In particular, the government leaned on the jurisdictional requirement in Section 7422 that a tax refund suit cannot be brought until a claim has been filed and the rule in Section 6511(b)(2) that “no credit or refund shall be allowed or made after the expiration of the period of limitation prescribed in [Section 6511(a)] for the filing of a claim for credit or refund, unless a claim for credit or refund is filed by the taxpayer within such period.”

While the government agreed that NetJets had filed a refund claim, it filed its claim before the Service had applied the later overpayments to the assessments that were at issue in the case. According to the government, its earlier claim was not a claim with respect to the later amounts. The evidence in the record did not indicate that NetJets filed a formal claim for those other applied amounts; nor did it amend its pleadings to specifically allege a return of those funds. While the government agreed to abate the unpaid assessments, it would not refund any of the amounts that were applied to the assessment after NetJets filed its original refund claim because there was no separate claim filed with respect to those latter amounts.

The district court agreed with the government, looking primarily to the statutory language in Section 6511(b)(2). To get around that statute’s rather clear language that tethers the government issuing a refund to a taxpayer filing a claim, NetJets argued that a plain language approach to the issue failed to effectuate legislative intent (preventing the litigation of stale claims) and produced an absurd result. The court disagreed, initially noting that Section 6511(b)(2) had no exception for divisible taxes and that the broad language of the statute suggested perhaps an intent that was not so clear to discern.

As to the absurdity of requiring a taxpayer to file a separate claim when litigation was already pending, the court disagreed with NetJets:

Plaintiffs point to the apparent absurdity of filing a new refund claim when the Court has already determined that the underlying tax assessment cannot be collected. The application of § 6511(b)(2) in this case is, admittedly, tedious. But it is hardly absurd. Where the IRS retains overpayments and applies them toward a divisible tax liability for which a claim has already been filed, the taxpayer, to comply with § 6511(b)(2), must take a simple action: file a new refund claim. And contrary to Plaintiffs assertion, a refund claim is not only a “challenge [to] the lawfulness of an underlying tax assessment.” More mundanely, and as relevant here, a refund claim is a formal request to the IRS for the return of a taxpayer’s money. See 26 C.F.R. 301.6402-2. Filing a refund claim does not become a superfluous task simply because the lawfulness of the underlying assessment has already been determined.

Conclusion

This is a harsh result for NetJets but the opinion suggests that all is not lost. While it is too late to file claim now, the opinion states that the government “hinted” that previously NetJets may indeed have filed another formal claim for some of the amounts. Moreover, the opinion discusses that NetJets may have submitted informal refund claims, though there was insufficient evidence in the record on that point, and a party who files an informal claim must also perfect that informal claim with a formal claim in order for a court to have jurisdiction.

While NetJets may be able to salvage some of its refund the lesson of this case is clear: if litigating a divisible tax refund suit taxpayers should be on the lookout for IRS applying any overpayments to the dispute that is at issue in the suit. Even if the taxpayer wins on the merits, absent a specific refund claim for those amounts, taxpayers are vulnerable to the government’s argument that it has not waived sovereign immunity.

NetJets Large Aircraft v US, 119 AFTR2d 2017-1246 (SD Ohio 2017)

Taft v. Comm’r: Innocent Spouse Relief Generates a Refund

We welcome back frequent guest blogger Carl Smith who writes about an innocent spouse case in which the Tax Court granted relief under a subsection permitting the innocent taxpayer to obtain a return of money previously taken from her to satisfy the liability caused by her ex-spouse.  Because the IRS frequently defaults to granting relief in a way that prevents the innocent spouse from obtaining refunds, this case shows a path to a more complete victory.  Keith

A number of people have congratulated Keith for contributing to a victory last month for a taxpayer seeking a $1,500 refund under the innocent spouse provisions at section 6015See Taft v. Commissioner, T.C. Memo. 2017-66.  Keith and I had filed an amicus brief in the case on behalf of the Harvard Federal Tax Clinic.  In it, we agreed with pro bono Florida attorney Joe DiRuzzo and his firm that a regulation on which the IRS relied to deny the refund under subsection (f) (equitable relief) was invalid – though invalid for different reasons than articulated by Joe and his firm.  But, as noted in footnote 4 near the end of the opinion, Tax Court Judge Vasquez never had to discuss the regulation’s validity, since he found the refund authorized under subsection (b) (traditional relief), even though the taxpayer had also been nominally granted relief under subsection (c) (separation of liability relief), which does not allow for refunds.  So, really, Keith and I did not win this case.  Rather, the taxpayer, aided by Joe and his firm, did.

In any event, the Taft opinion provides a useful reminder of some of the rules on getting a refund under the innocent spouse provisions.  And a post on it may alert others who find themselves in this position to the regulation invalidity argument.

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The traditional way to bring a refund suit is to file an administrative claim, which, if not allowed, forms the basis of a suit for refund in district court or the Court of Federal Claims.  But, when Congress, in section 6015(e)(1)(A), also gave the Tax Court stand-alone jurisdiction to “determine the relief available to the individual under” section 6015, that included also determining whether a taxpayer was due a refund, even in the absence of predicate unpaid taxes.  Thus, Ms. Taft had her choice of bringing this refund action in any of three federal courts.

The pro se Ms. Taft first filed a Form 8857 seeking a refund under section 6015.  Note that she could not have used a Form 1040X to seek the refund, since the year involved, 2010, was one in which she had filed a joint return, and she did not want to file a joint amended return with the former husband that she had divorced in 2013.  The IRS treats a Form 8857 as a refund claim for purposes of the section 6511 statute of limitations.  Prop. Reg. § 1.6015-1(k)(4) (Nov. 19, 2015) (“Generally the filing of Form 8857, ‘Request for Innocent Spouse Relief,’ will be treated as the filing of a claim for credit or refund even if the requesting spouse does not specifically request a credit or refund.”).  Her refund request was timely because the IRS had taken about $1,500 of her reported overpayment on her 2012 return (filed in 2013) and applied it to fully pay the 2010 joint deficiency at issue.  She filed the Form 8857 less than two years after the overpayment was applied, so she qualified under the 2-years-from-payment refund statute of limitations in section 6511(a).

Since, by the time she filed the Form 8857, she was divorced, she was entitled to elect (c) (separation of liability) relief.  This led to the first complication, since relief under (b) and (f) can entitle a taxpayer to a refund, but relief under (c) cannot.  Section 6015(g)(3).  The reason why Congress made a refund under (c) unallowable is because it made relief under (c) so easy to obtain.

Relief under (c) applies to deficiencies when, at the time the Form 8857 is filed, the taxpayer is divorced, legally separated, or has been living apart from the taxpayer’s spouse for at least 12 months.  For relief under (c), a taxpayer merely elects to separate his or her liability from that of his or her spouse based on their respective contributions to causing the deficiency.  In this case, the deficiency was tax on about $4,500 of unreported dividends from stock Mr. Taft owned and that he had acquired as an employee of the supermarket chain, Publix.  Mr. Taft had worked for many years at Publix until he was fired in 2009.  Relief is available under (c) even where it would not be inequitable to hold the electing spouse liable (e.g., where he or she significantly benefited from the underpayment and would have no hardship in paying the amount).  The only way the IRS can deny relief under (c) is for it to prove (note the burden shift) that the taxpayer had actual knowledge of the item giving rise to the deficiency.  The IRS concluded that Ms. Taft did not see the statements addressed to Mr. Taft that would have shown the exact amount of dividends that were unreported, so, in the notice of determination, the IRS conceded that Ms. Taft was entitled to relief under (c) because she did not have actual knowledge.  But, that relief under (c) did absolutely nothing for Ms. Taft, since she had (involuntarily) already fully paid the deficiency and was only seeking a refund, which could not be granted under (c).

The IRS then went on to deny Ms. Taft the refund under (b).  Under (b), relief is only available in the case of deficiencies if, among other things, a taxpayer had no reason to know of the deficiency and it would be inequitable to hold the taxpayer liable for the deficiency.  The IRS argued that she should have known that there were unreported dividends from Publix because for many prior years she had signed joint returns that reported such dividends.  The IRS also argued that it would not be inequitable to hold Ms. Taft liable for the deficiency.

Relief under subsection (f) (including refunds) is available if only two conditions are met:  First, relief is “not available” under subsections (b) or (c).  Second, it would be inequitable to hold the taxpayer liable for the deficiency or underpayment.  Reg. § 1.6015-4(b) (which applies to relief under (f)), states:  “This section may not be used to circumvent the limitation of § 1.6015-3(c)(1) (i.e., no refunds under § 1.6015-3) [i.e., the regulations under subsection (c)]. Therefore, relief is not available under this section to obtain a refund of liabilities already paid, for which the requesting spouse would otherwise qualify for relief under § 1.6015-3.”  This regulation was controversial before it was enacted in 2002.  It seems to prohibit a refund under (f) – even if the taxpayer can show that it would be inequitable for the taxpayer to be held liable for the deficiency – because of qualification for nonexistent relief under (c) (which does not require proof of inequity).  The IRS argued that since relief had been “available” to Ms. Taft under (c), she was not entitled to a refund attributable to the Publix dividend underreporting deficiency.  The IRS also argued that it was not inequitable to hold Ms. Taft liable, in any event.

Judge Vasquez held that, even though Ms. Taft could not get a refund under (c), she could get a refund under (b).  Mr. Taft had started an affair, which Ms. Taft discovered in 2011.  During 2010, Mr. Taft, unbeknownst to Ms. Taft, liquidated all the family savings (including the Publix stock) and spent them on himself and his girlfriend.  Wanting to conceal his affairs (both emotional and financial) from Ms. Taft, when it came time to prepare the 2010 joint Form 1040, he did so with the long-time accountant without her present and had the return e-filed.  That return revealed all the income from liquidating the family assets, though mistakenly left off the Publix dividends.  Mr. Taft did not let Ms. Taft see a copy of the return, though he assured her that it had been properly prepared by the long-time accountant.  Given all this secretiveness, Judge Vasquez held that Ms. Taft had no reason to know of the deficiency for purposes of that requirement for (b) relief.

Given the fact that Mr. Taft had wasted the family assets in his affair and so Ms. Taft did not benefit in the slightest from the Publix dividends and Ms. Taft’s lack of knowledge of the underreporting, Judge Vasquez also held that it would have been inequitable to hold Ms. Taft liable – another condition for (b) relief.

Since the judge granted Ms. Taft a refund under (b), he no longer had to reach the issue of refunds under (f) and the possible invalidity of the regulation under (f).

The Regulation’s Possible Invalidity

Joe DiRuzzo took on the Taft case pro bono at a Tax Court calendar call.  It was his first innocent spouse case, so, knowing I was experienced in this area, he gave me a call about it later that day.  We both were worried that the judge might find that Ms. Taft should have known about the unreported Publix dividends based on the prior-year reporting of similar dividends.  In that event, Ms. Taft could not get relief under (b), and the issue of relief under (f) (and the validity of the regulation under (f) possibly prohibiting a refund) would be squarely presented.

Despite the small amount involved in the case, Joe asked the court for permission to do post-trial briefs.  And he then immediately did a FOIA request of the IRS for all comments submitted on the proposed regulations that were finalized in 2002.  Finding a few comments objecting to the proposed (f) refund regulation limitation and not feeling the IRS had adequately responded to those comments, in his brief in Taft, Joe challenged the validity of the regulation under the Administrative Procedure Act.  He made the same argument that had recently been successful in Altera Corp. v. Commissioner, 145 T.C. 91 (2015) (currently on appeal in the Ninth Circuit):  that the IRS had not sufficiently responded to the comments or provided a “reasoned explanation” for why it reached the result that it did under the standard set out in Motor Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983).

Keith and I then got permission from the court to weigh in as amicus, arguing in our brief in Taft that the regulation was invalid under the tests of Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).  We argued that the regulation added a limitation on getting a refund under (f) that was not in the statute – i.e., preventing circumvention of the no refund rule of subsection (c).  We pointed out that there could be no circumvention because a refund under (f) was not automatic, since, under (f), one had to prove inequity (something that was irrelevant under (c)).  We cited to the Tax Court’s opinions in Lantz v. Commissioner, 132 T.C. 131 (2009), revd. 607 F.3d 479 (7th Cir. 2010), and Hall v. Commissioner, 135 T.C. 374 (2010), which made similar points that the 2-year period for requesting (f) relief imposed by § 1.6015-5(b)(1) did not need to be imposed to prevent the circumvention of the 2-year periods provided by statute for (b) and (c) relief because (f) relief (by contrast) requires additional proof of a number of events that may occur years after the returns are filed.

In the end, the work that Joe DiRuzzo and his firm and that Keith and I did was irrelevant to the court’s decision to grant a refund in Taft under (b).  But, we know this situation occurs now and then.  Recently, at least one attorney with a section 6015 refund case contacted me with the same problem concerning refunds under the regulation under (f) where useless (c) relief was arguably “available”.  I have linked to the two briefs filed in the Taft case, just in case anyone might be helped in a future litigation by seeing the arguments we raised.  And readers should also know that Joe DiRuzzo has on a disk copies of all the comments made on the section 6015 regulations that were adopted in 2002, which is not only a resource for this issue under the (f) regulations, but for any other challenge to the 2002 regulations.

Finally, I would note that the IRS proposed new section 6015 regulations on November 19, 2015, that are still awaiting adoption.  The proposed regulations retain the current sentences quoted above, but add this:  “For purposes of determining whether the requesting spouse qualifies for relief under § 1.6015-3, the fact that a refund was barred by section 6015(g)(2) [res judicata] and paragraph (k)(2) of this section [no refunds under (c)] does not mean that the requesting spouse did not receive full relief.” Prop. Reg. § 1.6015-1(k)(3).  The IRS is trying to buttress its argument that even relief under (c) that is, as a practical matter, useless (because no refund is allowed under (c)), is relief that precludes a refund under (f).

 

Innocent Spouse Injured by Using the Wrong Form

The difference between innocent and injured spouse can create confusion.  That confusion gets illustrated in the case of Palomares v. Commissioner, T.C. Memo 2014-243 which will soon be argued before the 9th Circuit by a student at the tax clinic at Gonzaga Law School.  The case illustrates something that regularly happens in innocent spouse case – the innocent spouse’s refunds get offset by the IRS to satisfy the liability of the “liable” spouse – and getting them back can prove very difficult for the innocent spouse.

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For anyone unfamiliar with the innocent spouse and injured spouse provisions, I will briefly discuss the distinction between the two types of relief.  Innocent spouse relief allows a spouse who has filed a joint return to obtain relief from the joint and several liability that results from filing a joint return if the spouse requesting relief meets certain criteria set out in IRC 6015(b), (c) or (f).  Injured spouse relief allows a spouse who files a joint return to recover the portion of the refund resulting from that return which relates to the liability of the requesting spouse when the refund would otherwise go to satisfy a tax, or other liability subject to offset, owed solely by the other spouse.  While both forms of relief result from filing a joint return, the goal of each type of relief differs and the difference can create confusion for someone who does not regularly handle these types of cases.

Ms. Palomares got confused.  She needed innocent spouse relief but filed Form 8379 designed for use by injured spouses.  The IRS recognized her confusion and provided her with the correct form, Form 8857.  Upon receipt of the correct form, Ms. Palomares eventually filed it but the delay creates the issue in the case.  The IRS determined she deserved some relief as an innocent spouse; however, the delay in filing the correct form limited that relief.  After incurring the joint liability for which she sought innocent spouse relief, Ms. Palomares found that the IRS took the refunds she claimed in subsequent years in order to satisfy the unpaid liability on the joint return.  In seeking innocent spouse relief, she also wanted a return of the refunds the IRS had offset against the joint liability.  The issue here turns on the timing of her request for refund, which turns on whether the filing of the incorrect form nominally seeking injured spouse relief can meet the requirements of the informal claim doctrine allowing her request for relief to relate to the date of filing the injured spouse relief rather than the date of filing the correct form for innocent spouse relief.

In addition to the general confusion that exists between innocent and injured spouse relief, Ms. Palomares had the additional handicap that English was not her first language, and she spoke very little English.  The years at issue for the refund are 2005 through 2008.  By these years, she had separated from her husband, and she filed returns using the filing status of head of household.  As mentioned above, the IRS took the refunds reflected on these returns as it should using the power of offset granted in IRC 6502.  When she did not receive her refunds for 2006 and 2007, she sought assistance from the Northwest Justice legal clinic which helped her fill out the wrong form on July 1, 2008.  This clinic is not a low income taxpayer clinic but a clinic providing general legal assistance.  On September 24, 2008, the IRS sent her a letter with the correct form.  The Court found that “She did not call or otherwise contact respondent with respect to the September 24 letter.”

Ms. Palomares’s life intervened and kept her from focusing on her taxes for almost two years.  Finally, in August, 2010, she filed the Form 8857 seeking innocent spouse relief with the correct form and seeking a return of the refunds taken from her for four years.  Initially, the IRS took the position that the request came too late because she sent it more than two years after collection activity had begun; however, on May 14, 2012 the IRS reversed its position regarding the two year rule and requests for relief under IRC 6015(f).  The IRS granted her relief as an innocent spouse; however, it limited her refund to amounts paid within two years of the filing of the Form 8857 in 2010.  She appealed arguing that the relief should date from the submission of Form 8379 and that is the issue before the court in this case.

The Tax Court found that the Form 8379 did not meet the requirements for an informal claim.  The requirements for an informal claim do not come from a statute since this is an equitable remedy constructed by the courts to prevent an injustice.  As the Court notes, the sufficiency of an informal claim largely turns on the facts; however, courts generally look for certain markers in deciding whether to treat something other than a formal claim for refund as an adequate informal one.  The underlying principle concerns exhaustion of administrative remedy and whether the IRS had a chance to consider the request.  The more the taxpayer can show that the inappropriate document filed essentially apprised the IRS of what it needed to know in order to grant a refund, the more likely the taxpayer will succeed.

The Court states that a qualifying informal claim must satisfy three requirements.  It quoted from a non-precedential memo opinion to set out the requirements:

It has long been recognized that a writing which does not qualify as a formal refund claim nevertheless may toll the period of limitations applicable to refunds if (1) the writing is delivered to the Service before the expiration of the applicable period of limitations, (2) the writing in conjunction with its surrounding circumstances adequately notifies the Service that the taxpayer is claiming a refund and the basis therefor, and (3) either the Service waives the defect by considering the refund claim on its merits or the taxpayer subsequently perfects the informal refund claim by filing a formal refund claim before the Service rejects the informal refund claim. Jackson v. Commissioner, T.C. Memo 2002-44, slip op. at 10.

The Court found that the Form 8379 meet the first test citing to Kaffenberger v. United States, 314 F.3d 944 (8th Cir. 2003).  The Court found that the Form 8379 did not convey sufficient information to notify the IRS that Ms. Palomares sought relief from the liability created by the joint return with her then husband and sought a refund of amounts applied to the liability created by the joint return.  The Court determined that sending her the form for innocent spouse relief amounted to guess by the IRS that she might have intended to request that relief rather than an awareness that she wanted such relief.  The Form 8379 did not reference 1996, the year for which she wanted innocent spouse relief.  Because it did not reference that year, the IRS lacked sufficient clues to know exactly what she wanted and to make a determination based on her Form 8379 other than that the form she sent did not work for the circumstances of her situation since she had not filed a joint return in the years to which the form related.  So, the Court denied her claim for refund based on the date of filing the Form 8379.

Ms. Palomares presents sympathetic facts.  She clearly did not know the difference between innocent spouse and injured spouse, and neither did the clinic that assisted her with her divorce and that helped her file the wrong form.  The IRS gave her the correct form relatively quickly but she delayed filing that form because of things happening in her personal life.  She appears to deserve the refunds she seeks.    The case deserves watching as it heads into argument in the 9th Circuit because of the effort to expand the informal claim doctrine into an area of some confustion.  If the IRS loses, it will probably do so because it was nice and sent her the innocent spouse form.  The outcome turns on whether the IRS knew what she wanted to a degree that would have allowed it to make an innocent spouse determination at the time it received the injured spouse form or instead made an educated guess based on the unavailability of the relief requested on the form she submitted and the confusion surrounding these two similar but different forms of relief available to spouses.