What Does “Prior Opportunity to Dispute a Liability” Mean?

In Keller Tank Services II, Inc. v. Commissioner, No. 16-9001 (Feb 21, 2017) the 10th Circuit upheld the Tax Court’s determination of “prior opportunity to dispute a liability.”  The Tax Court, in turn, upheld the IRS determination of this phrase in the Collection Due Process (CDP) regulations.  The 10th Circuit went through a Chevron analysis of the statute and the regulation in making its decision to uphold the regulation.  We have discussed this issue previously here, here, here and here.  The last link discusses in detail that Keller Tank is the first of three recent circuit court arguments by Lavar Taylor challenging the regulation.

The result here is disappointing for those of us hoping that the CDP process can provide a pre-payment forum for tax liabilities, usually a penalty, that do not have the benefit of the deficiency process and are not divisible.  For these liabilities, the decision in Keller Tank places the taxpayer in the unenviable position of having an Appeals Officer as the only person standing between them and a sometimes crushing liability for which they will never have the opportunity to litigate because paying several million dollars to satisfy the liability and the Flora rule is not a possibility.

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The IRS asserted a penalty under 6707A against Keller Tank for engaging in and failing to report a listed transaction.  This case does not reach the merits of the penalty assessment and finds that the taxpayer cannot contest the merits in the CDP case.  The 10th Circuit correctly points out that the taxpayer still has an opportunity to contest the merits through a refund suit.  It does not mention that in many cases that opportunity is illusory because of the amount of money the taxpayer would have to pay in order to satisfy the Flora rule.  The amount of the penalty in Keller Tank is not so high that it presents a practical inability to pay; however, I have no idea if the amount, though not astronomically high, still exceeds the taxpayer’s ability to pay.

Section 6330(c)(2) describes the matters that can be heard at a CDP hearing.  Subparagraph (B) under that section provides that

“The person may also raise at the hearing challenges to the existence or amount of the underlying tax liability for any tax period if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.”

Treas. Reg. 301.6320-1(e)(3) addresses matters considered at a CDP hearing.  The regulation is primarily in Q&A format.  Q-E2 asks the question:

“When is a taxpayer entitled to challenge the existence or amount of the tax liability specified in the CDP notice?”

A-E2 answers that question in a long paragraph that includes the following statement:

“An opportunity to dispute the underlying liability includes a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability.  An opportunity for a conference with Appeals prior to the assessment of a tax subject to deficiency procedures is not a prior opportunity for this purpose.”

The language of the regulation stating that the conference with Appeals satisfies the requirement of section 6330(c)(2)(B) formed the basis for the appeal.  The taxpayer argues that this language conflicts with the intent of the statute.  The IRS refused to allow the taxpayer to argue the merits of the penalty in the CDP hearing because it had a prior opportunity to address the merits of the penalty during the assessment phase although that opportunity did not include the ability to contest the assessment of the penalty in a pre-assessment judicial forum.  According to the IRS, that opportunity arose after the IRS issued a 30-day letter because the taxpayer submitted a written protest challenging the grounds for issuing the penalty and participated in a telephone conference, which resulted in Appeals sustaining the penalty.  The Tax Court agreed with the determination CDP by Appeals on this point which was the only point raised by the petitioner in the CDP request.  On appeal to the 10th Circuit, Keller Tank argued that the refusal to allow it the opportunity to raise the merits of the penalty assessment in the CDP process violated the goal of the statute and that the regulation impermissibly frustrated that goal.

The regulation creates a clear distinction between taxes governed by the deficiency procedures and those that are not.  A taxpayer with a liability covered by the deficiency procedures can have a pre-assessment conference with Appeals at which Appeals sustains the liability proposed by the Examination Division.  If the taxpayer does not receive the notice of deficiency, the taxpayer can raise the merits of the underlying liability in the Tax Court in the context of a CDP hearing because of the failure of the opportunity to go to Tax Court prior to the assessment due to the non-receipt of the notice of deficiency.  In this situation, the IRS must have mailed the notice of deficiency to the taxpayer’s correct address or the taxpayer could set aside the assessment.  Yet, Congress recognized that sometimes taxpayers did not receive the notice of deficiency and sought to give them an opportunity to have their day in court because of the non-receipt of the notice.

In contrast a taxpayer with a liability not governed by the deficiency procedures offered an opportunity to meet with Appeals prior to or after the assessment of the liability, receives no opportunity to have their day in court through the CDP process even though they previously had no opportunity to go to court to contest the merits of the liability.  For these taxpayers, the right to contest the liability through the refund procedure remains their only path to court.  The regulation acknowledges that taxpayers whose taxes are assessed through the deficiency process are not limited to only using the refund procedure while forcing the refund procedure on those taxpayers whose liabilities did not related to a tax assessed through the deficiency process.  The 10th Circuit and the Tax Court find that regulation reaches a logical result in interpreting an unclear statute despite the distinction it draws between the types of taxes.

To sustain the Tax Court decision, the 10th Circuit engaged in a Chevron analysis of the regulation.  It first looked at the language of the statute to determine if the language of the statute spoke to the precise question at issue and determined that it did not.  The 10th Circuit agreed with the Tax Court that the “otherwise have an opportunity to dispute” language in the statute was ambiguous and was not defined in the 1998 legislation creating the language or elsewhere in the Internal Revenue Code.  That determination allowed the Court to move on to step 2 of the Chevron analysis which looks at the interpretation of the statute by the regulation in question in order to decide if that interpretation is based on a permissible construction of the statute.  The 10th Circuit again agreed with the Tax Court that a reasonable interpretation of “opportunity to dispute” includes “a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability.”  A factor influencing both the Tax Court and the 10th Circuit is the failure of Congress to simply say that a taxpayer who has not had a prior opportunity for judicial review will receive on in the CDP process.  No doubt, this is a strong basis in support of the decision.

The 10th Circuit opinion has a paragraph that attempts to support its determination using logic I cannot follow.  It suggests that accepting the taxpayer’s argument would promote similarly situated taxpayers to skip the conference with Appeals and wait until collection begins so they can go directly to court.  Few taxpayers would want to pass up an opportunity to resolve their problem at the lowest level in the cheapest way simply so they could argue a case before a court.  Taxpayer’s argument in favor of an opportunity to go to court does not minimize the importance of Appeals and does not undercut the importance of the informal conference.  To the extent the 10th Circuit relied on this logic to reach its conclusion, I think its based its decision on flawed reasoning.

After reaching its conclusion, the 10th Circuit doubled back to address arguments presented by the taxpayer.  Keller Tank argued that the regulation impermissibly limits the jurisdiction of the Tax Court through a regulation because the regulation limits the matters the Tax Court may hear.  The 10th Circuit finds that the regulation does not diminish the Tax Court’s jurisdiction but only limits what may be heard in the administrative process before the IRS in a CDP proceeding.  Because the limitation is on the administrative process and not on the Tax Court, even though the Tax Court is limited to addressing matters that may be raised in the administrative hearing, the 10th Circuit finds that the regulation does not directly limit the Tax Court’s jurisdiction.  Not only is this logic unsatisfactory but the opinion goes on to throw in an additional paragraph here noting that taxpayers have the ability to bring a refund suit without discussing the realities of this ability.

Next, the 10th Circuit addresses taxpayer’s argument that the regulation contains internal inconsistencies.  Keller Tank first argued that the regulation “is inconsistent because it precludes liability challenges at a CDP hearing even when the taxpayer failed to exercise its opportunity to dispute liability at the Appeals Office and was therefore not actually heard.”  Because the statute on speaks to “opportunity” and not to an opportunity the taxpayer exercises, the 10th Circuit finds that the regulation is consistent with the statute and it promotes the statutory purpose of encouraging taxpayers to meet with Appeals.  Keller Tank next argued the regulation was inconsistent “because it precludes liability challenges at a CDP hearing for some, but not all, prior administrative opportunities.”  Keller Tank’s argument here goes to the discrepancy between taxes arises under the deficiency process and those outside that process.  The 10th Circuit simply finds that the distinctions are not “unreasonable or arbitrary or that it is inconsistent to treat different administrative proceedings differently.”

One down and two to go

Arguments occurred within a short time in three circuits.  Taxpayers have lost the first but have two more opportunities.  If the arguments do not succeed, perhaps the judicial interpretations of the language in the statute will persuade Congress to fix the inconsistency between deficiency and non-deficiency process taxes and allow all taxpayer to have a day in court before they must pay.  Congress seemed to want that result in 1998 when it passed the CDP provisions.  If the courts cannot be persuaded that Congressional language allows that result, it is time to push for legislative change.  Because many, though certainly not all, of the people assessed penalties through the non-deficiency process are people with whom few legislators will be excited to assist, getting a legislative change may prove difficult.

 

 

Quick Follow Ups on Vigon v. Commissioner and Private Debt Collection

Vigon

I recently wrote about an order in the case of Vigon v. Commissioner in which Judge Gustafson provided instruction to respondent’s counsel because of a failure to lay the proper foundation for a the summary judgment motion.  IRS Counsel took the instruction to heart quickly and requested a continuance for a trial scheduled for February 22, 2017.  The IRS now agrees that petitioner is not liable for the penalties at issue in the case and stated in its motion that it was in the process of abating the penalties.  The IRS further stated that it was in the process of releasing the liens.  This is a great result for a pro se taxpayer who did not initiate the arguments resulting in these concessions.  The Court granted the continuance but had a question for the IRS:

“We understand how collection issues under section 6330(c)(2)(A) become moot if collection activity ceases. It is less clear how a liability challenge under section 6330(c)(2)(B) becomes moot merely upon an announced concession, which would not seem to have any res judicata or collateral estoppel effect. Perhaps a CDP petitioner who makes a liability challenge that the IRS concedes is entitled to decision in his favor on the liability issues.”

So, the Court ordered the IRS to make an appropriate filing by March 24, 2017, and to explain in the filing how it provide adequate relief to the petitioner on the merits side of this case.

Private Debt Collection

I also recently wrote about private debt collection and wanted to provide a quick update.

The IRS recently released sample CP40 notice letter.  The letter alerts the taxpayer that their account has been assigned to a PDC.  The hope is that the letter will prepare the taxpayer for the call(s) from the PDC and keep the taxpayer from having concerns that the PDC is a scam artist.

 

 

Tax Court Holds It Does Not Have Jurisdiction to Consider Reasonable Salary Determination in Exams of S Corps

Last month in Financial Consultant Fails To Avoid Self-Employment Tax With S Corp Structure we discussed the possible ways that service-performing employee/shareholders in S Corps can minimize employment taxes. IRS is aware of the abuses in this area and seems to be looking carefully at S Corps that are profitable and pay what it thinks are low wages to those key employee/shareholders.

In the last few weeks there have been some interesting Tax Court orders considering a jurisdictional issue spinning from IRS audits of S Corps and their shareholders.

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First some background.

Individuals who earn service income directly have to pay Social Security and Medicare taxes, which are often referred to collectively as the self-employment tax. [Note that the tax rate for Social Security taxes is 12.4% and the rate for Medicare taxes is 2.9%; for 2017 Social Security taxes are levied only on the first $127,200 while the Medicare rate applies to all service income]. If the S corporation, rather than the individual, earns that income, then the S corporation does not have a separate employment tax liability and the shareholder does not have self-employment tax liability on his share of the S corporation’s income.

The scheme minimizes employment tax obligations by essentially paying below market wages to the S Corporation’s shareholder/employee; cash still comes out to the shareholder/employee in the form of other distributions.

As part of an IRS audit, IRS will examine the S Corp’s return and analyze the reasonableness of the salaries. If IRS thinks the wages are not high enough, it will send the S Corp a Form 4668, Employment Tax Examination Changes Report, which can propose what it thinks the reasonable salary is and thus propose employment tax increases (as well as penalties). Interestingly, this is the reverse of old reasonable compensation cases where C Corp shareholder/employees would pay themselves a salary that IRS argued was too high. As Keith notes and based on his experience in litigating a couple of those older reasonable compensation cases (see, e.g., Royal Crown v Comm’r) these are time-consuming to litigate and, as with many valuation cases, often involve expert testimony.

As a substantive matter, the key inquiry should be whether the payments that the shareholder received that were not labeled as compensation were remuneration for services. Not surprisingly, comparables are key, and IRS will look to industry and regional standards.

This brings us back to the procedural issues.

In response to the IRS issuing an Employment Tax Examination Changes Report (Form 4668) some S Corps have filed petitions to Tax Court to attempt to get the Tax Court to consider the reasonableness of the salaries.

Employment taxes are generally not subject to the deficiency procedures. The Tax Court has jurisdiction under Section 7436 to consider proceedings relating to determinations of an individual’s employment status. (Lavar Taylor has discussed this provision extensively in his series of posts considering the SECC v Commissioner case).

Even though the S Corps are not getting a notice of deficiency in a couple of recent cases they have essentially claimed that the IRS’s adjustments to the salaries that the corps paid to its shareholders are determinations for purposes of Section 7436.

The Tax Court has disagreed stating that the IRS adjustments have nothing to do with a determination of employee status but only relate to the amount of salary that should have been paid to someone who the parties already agree is an employee.

To that end, see the discussion in Azarian v Commissioner, involving a S Corp that operated a law firm and had a sole shareholder, where the Tax Court granted the IRS’s motion to dismiss on the grounds that it did not have jurisdiction:

Petitioner consistently treated Mr. Azarian as an employee for the taxable periods at issue. Therefore respondent did not make a determination that Mr. Azarian was an employee of petitioner, but rather concluded that petitioner failed to report reasonable wage compensation paid to Mr. Azarian for 2012-14. Section 7436(a)(1) only confers jurisdiction upon this Court to determine the “correct and the proper amount of employment tax” when respondent makes a worker classification determination, not when respondent concludes that petitioner underreported reasonable wage compensation, as is the case here.

The Tax Court took a similar approach in Arroyo Corp v Commissioner, also an S Corp exam looking at the reasonableness of salaries to shareholder/employees, where it stated that while the IRS made a determination with respect to the amount of the compensation, that was insufficient to generate jurisdiction under Section 7436.

Conclusion

S Corps wishing to challenge the IRS on these issues will likely have to go the refund route, though given the divisible nature of employment taxes those corporations need not fully pay any proposed liability. The Tax Court has closed one door though it is possible that a CDP proceeding could allow a taxpayer to challenge the liability, though that issue spins off other procedural issues, including whether the S Corp had a prior opportunity to challenge the liability. That issue is subject to considerable uncertainty, though last week’s Tenth Circuit opinion in Keller Tank v Commissioner sustained the Tax Court and IRS’s restrictive approach to the definition of prior opportunity (stay tuned as we will blog that case this week).

Tip of the hat to our hard-working blogging colleague Lew Taishoff, whose blog on the Tax Court brought these recent orders to my attention.

 

 

The Sixth Circuit’s Summa Bomb-shell

We welcome back guest blogger Stu Bassin. Stu is a solo practitioner in Washington, D.C. who specializes in tax controversy work. Today he talks about Summa Holdings v Commissioner, where the Sixth Circuit disagreed with the IRS and Tax Court’s applying a substance over form analysis. The role of anti-abuse provisions in the tax law is controversial, and Stu discusses how taxpayers, the Service and courts are likely going to wrestle with these concepts when IRS challenges transactions that may technically satisfy statutory requirements but seem to be inconsistent with broader tax principles. Les

 The Sixth Circuit issued a remarkable opinion last week, giving the taxpayer a full victory in what the Service tried to characterize as a tax shelter. The decision in Summa Holdings v. Commissioner, No. 16-1712 (6th Cir. February 16, 2017), reversed a Tax Court ruling in favor of the Service and represents the most decisive and significant appellate victory for a taxpayer in the area of judicial doctrines in over a decade.

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The Summa case arose out of a clever strategy in which a closely-held corporation employed a Domestic International Sales Corporation (“DISC”) and a Roth IRA to transfer corporate profits into its shareholders’ hands with a minimal tax bite. To briefly summarize, the statutory regime governing DISCs allows companies to defer income on the portion of the DISC’s which is distributed to the DISC’s shareholders as a dividend. The DISC’s shareholders receive the dividend without paying a corporate level tax. The novel twist in Summa was that the DISC’s shareholder was a Roth IRA—an entity which does not pay taxes on its earnings. Thus, neither the DISC nor the taxpayer would pay tax on the remainder of the dividend or on future earnings within the Roth IRA, although the taxpayer would pay an unrelated business income tax on a portion of the dividend received.

Upon audit, the Service recognized that the taxpayer’s strategy satisfied all of the statutory requirements for the treatment it sought under the DISC and Roth IRA statutory provisions. Nonetheless, the Service determined that the “substance over form” doctrine applied and that the payments would not be treated as DISC dividends, but would instead be treated as dividends from the parent company to the shareholders—a recharacterization which substantially increased the shareholders’ tax liability. To add insult to injury, the Service also added a substantial understatement penalty. The Tax Court upheld the Service’s determinations and the taxpayer appealed. In the Summa decision, the Sixth Circuit reversed, ruling that the Service could not apply the substance over form doctrine to the disputed transaction.

The issue, in the court’s view, was whether the Service had crossed the elusive “line between disregarding a too-clever-by-half accounting trick and nullifying a Code-supported tax-minimizing transaction”—the same broad issue which arises in many so-called “tax shelter” cases.  Both sides agreed that, in form, the transactions complied with the text of the Code, but disagreed whether the substance-over-form doctrine could nonetheless be invoked. Rejecting the Service’s position, the court observed that tax law is governed by a highly nuanced set of rules articulated with nearly mathematic precision, particularly in the DISC arena and that “all areas of law that should resist judicial innovation based on misty calls to higher purposes, this would seem to be it.” While endorsing application of judicial doctrines in some cases involving factual shams and transactions which have no legitimate non-tax business purpose, the court concluded that the doctrine “does not give the Commissioner a warrant to search through the  . . . Code and correct whatever oversights Congress happens to make or redo any policy missteps the legislature happens to make.” If Congress found the result improper, it could amend the statutes, but it was not the role of courts to legislate.

Read broadly, the Summa decision is a bomb-shell; it breaks a decade-long string of Service victories in appellate cases which rest upon application of judicial doctrines like the substance-over-form rule to undo transactions which the taxpayer designed to comply with the literal language of the Code (the most recent taxpayer victories were in 2001 in the 5th Circuit Compaq Computer v Commissioner and 8th Circuit in IES Industries v US). In almost all of the cases where the government prevailed, the taxpayer argued that it had complied with the Code and that it was inappropriate to invoke judicial doctrines or to judicially legislate based upon a judge’s gut reactions to particular transactions. While most of the appellate courts have sided with the Service, the opinion of the Sixth Circuit emphatically rejected the Service’s position—complete with an allusion to Caligula.

Where the case goes from here is a great topic for speculation.   The recurring question of the parameters of the judicial doctrines is not going to go away and Summa potentially represents a very important conflict between the circuits. However, presentation of that fundamental issue is probably something the Government will likely try to avoid; a large body of Service-favorable law has developed since the Supreme Court’s last “judicial doctrine” ruling–the 1978 Frank Lyon decision. The vitality of all that law would be in play if Summa were to reach the Supreme Court.

Recognizing the stakes which would be at risk in a Supreme Court ruling on Summa, the Service and the Solicitor General are more likely to dodge the issue by offering a narrow reading of Summa, attempting to confine its reach to cases involving statutory grants of narrow tax benefits to a particular favored category of taxpayers such as DISCs. Indeed, the argument for application of generalized judicial doctrines to avoid tax avoidance is much weaker where Congress has so explicitly granted specific benefits which allow tax avoidance—benefits like those granted to DISCs and applied in Summa. Of course, the Government prevailed in a comparable context in the Third Circuit’s Historic Boardwalk ruling (which involved statutory rehabilitation tax credits), and it would be difficult to reconcile the two cases, but the conflict would be far less significant and is likely a matter which the Government would let stand before it ran the risk of a new Supreme Court decision on the judicial doctrines.

Continued Developments in Private Debt Collection

Based on the resounding failure of past efforts at private debt collection of federal taxes chronicled by the National Taxpayer Advocate and others here, here, here, here,  and here or perhaps based on the need for certain members of Congress to aid their constituents in the business of private debt collection discussed here and here, Congress revitalized IRC 6306 and enacted IRC 6307 on December 4, 2015 as part of the Fixing America’s Surface Transportation Act legislation requiring the IRS to once again use private debt collectors to collect accounts which the IRS has sitting on its shelf gathering dust.  I described the bill in an earlier post.  I will not again point out that over the past six plus years Congress has severely cut the IRS budget so that it does not have the resources to collect many of the accounts sitting on its shelf or to train its staff in how to appropriately collect that debt or that debt collection seems like an inherently governmental function which should not be privately sourced.  Instead of rehashing what a bad idea this is, I will try in this post to talk about what is about to happen with respect to private debt collection.

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Although the IRS was supposed to start using private debt collectors by now, it has not been sitting on its hands over the past 14 months but has been moving to the reimplementation of private debt collectors (PDCs) as Congress required it to do.  We should expect accounts to move into the hands of the PDCs within the next couple of months and the phones begin to light up as the PDC employees begin to contact the taxpayers whose accounts were turned over to them.  The IRS just issued Publication 4518 which provides some information on what taxpayer should expect with the coming of the PDCs.

Distinguishing PDCs from Scam Artists

One of the biggest issues surrounding the use of PDCs this time around concerns the proliferation of scam artists in the past couple of years who have preyed on people scared of the IRS and willing to believe that the scam artist represented the IRS.  So, the injection of a non-governmental player into the system has the potential to exacerbate the problem created by the scam artist.  One of the big problems for the IRS in the roll out of the PDC program addresses the concerns that taxpayers will have when contacted by a PDC.  The IRS has had its own employees questioned with respect to their authenticity.  It will be interesting to see how this plays out.  In its publication, the IRS addresses the problem by noting that it will send the taxpayer a letter advising the taxpayer their account has been assigned to a PDC and the PDC will send the taxpayer a letter confirming the assignment.  This will allow the taxpayer, in theory, to be comfortable that the call from the PDC represents a legitimate call and not a scam.  Two paragraphs in the publication address this issue:

What will the private collection agency do? The private collection agency assigned to your account is working on our behalf. They will send you a letter confirming assignment of your unpaid tax liability and then contact you to resolve your account. They will explain the various payment options and help you choose one that is best for you.

How can I be sure it is the private collection agency calling me? The private collection agency will send you a letter confirming assignment of your tax account. The letter will include the same unique taxpayer authentication number that is on the letter sent to you from the IRS. As part of the authentication process the PCA employee will use the unique number for identity verification. Keep both letters in a safe place for future reference.

Exclusion from Being Sent to PDCs

Moving past the issue of the authentication of the PDC, another issue facing the IRS as it assigns accounts to the PDC is which accounts should be assigned.  The IRS created an initial list of ten types of accounts that would not be assigned to PDCs.  This list can be found on its web site describing the program.  The list does not need to stop with the ten types list on the web site and depends on how the IRS decides to assign accounts and what Congress intended the IRS to do.  The answer to that question turns in part on how you view the authority of the IRS with respect to the creation of the PDCs.  If you take the view that the IRS does not have inherent authority to hire PDCs and that its authority derives only from the statute, then you would look at the statute as the sole source of authority for choosing the accounts to go to the PDCs.  Under this view, the IRS can only send to the PDCs the things specifically granted in the statute.  The interpretation of the statute on this point seems to have created some disagreement within the IRS, with the National Taxpayer Advocate taking the view that the statute provides a narrow grant of authority, while others in the IRS or Chief Counsel take a more expansive view.

The statute uses the term ‘potentially collectable inventory’.  What does that mean?  Together with others led by Chi Chi Wu at the National Consumer Law Center, I argued that the term, not defined in the Code, should be interpreted to exclude the same types of taxpayers the IRS excludes from the Treasury offset program.  This would exclude individuals on fixed income falling below 250% of poverty, which is a line used for other purposes in the Code including the cut off for services from low income taxpayer clinics.  The IRS leadership was kind enough to give us a high level meeting to discuss this and other issues regarding PDCs but did not agree with our view on the statute.  The IRS has continued to debate the IRS into the office of the Commissioner.  At present it seems that the IRS will not send to PDCs cases that have already achieved the Currently Not Collectible (CNC) categorization because it considers these as closed cases.  Everyone acknowledges that CNC cases can come out of that category and that the IRS can offset refunds to collect from cases in that category, but these cases will nonetheless not get sent to the PDCs – a decision that makes a lot of sense particularly when you consider that PDCs do not have the authority to place a case into CNC.

The Commissioner has also agreed to place a freeze on sending SSDI and SSI cases to the PDCs under the presumption that, even though a specific taxpayer receiving these payments may not yet have received the CNC designation, such a designation would likely occur if the IRS took a hard look at the case.  The Commissioner’s decision may have little practical impact if the IRS does not have the programming to cull these cases from the ones sent to the PDCs.  This is a big victory for consumers if the practical effect of IRS computer limitations does not totally undercut the decision.  The Commissioner did not decide to exclude taxpayers receiving regular social security or railroad retirement payments from referral because those individuals might have assets that would lift them out of CNC.  All cases pending in TAS will be excluded from referral and the National Taxpayer Advocate will likely issue an order that TAS will take any case in which the PDC seeks to collect from a taxpayer as she did the last time PDCs existed.  The NTA has the power to create special designations of public policy cases that qualify for the services of her office as I have discussed in a prior post.  Expect an order on this in the near future.

Voluntary Payments

Another issued presented by PDCs is how many times they can contact a taxpayer who does not have the ability to enter in an installment agreement but is willing to make a voluntary payment.  Many taxpayers do their best to avoid paying the IRS anything, but a significant number of taxpayers who owe the IRS try hard to pay off the debt even in the face of significant financial odds.  I spoke to a prospective client recently who owes the IRS about $2,000.  Last year she only made $2,500 yet somehow she is on an installment agreement and makes a $25 a month payment.  She called because she had a question on the offer in compromise form she could not answer.  Her mother was willing to give her money that would satisfy almost half of the outstanding liability.  I love her commitment to paying her taxes but I explained to her that with her financial situation we could make an offer for a much lower amount and that she could stop immediately making the monthly payments.  She did not want to stop.  That’s ok because that is her decision and what makes her feel right; however that attitude can be exploited.

Many others like my prospective client exist and the PDCs can obtain from them voluntary payments even though the individual falls into a hardship category and would not have to pay.  The issue before the IRS concerns how many voluntary payments can the PDC solicit from one taxpayer.  Keep in mind that the PDC gets paid for money it collects.  So, it has an incentive to keep going back to the well for people who have demonstrated a willingness to make a voluntary payment.  The PDCs, as mentioned above, do not have the ability to place the individual into CNC status, so they can just keep calling month after month or week after week or day after day trying to squeeze another voluntary payment out of the individual unable to enter into an installment agreement.  Does the statute allow the IRS to authorize the PDCs to make multiple calls for voluntary payments or, put another way, does the statute require the IRS to limit the PDCs in the number of calls made for voluntary payments.  Framing the question can drive the answer.  The Commissioner has apparently decided that the PDCs can make one, but not multiple, request for a voluntary payment.  This is a major victory for consumers because the calls can quickly become harassing if the PDCs have open season on these individuals.

Who are the PDCs

The IRS chose four PDCs.  The PDCs selected are Conserve, Pioneer, Performant and CBE Group.  One of these has recently been deselected by the Department of Education for apparently not following the rules for private debt collection of loans in a program administered by that department.  PDCs do not have a good reputation in the world of consumer law.  While that is natural and not unexpected, it means that taxpayers and their representatives should be looking out for practices that seem inappropriate.   To make a complaint about a PDC call the Treasury Inspector General for Tax Administration (TIGTA) hotline at 800-366-4484 or write to www.tigta.gov.  Like the IRS, PDCs are covered by the restrictions set out in IRC 6304 which I have discussed in prior posts here and here.  Consumer advocates requested great restrictions and more openness regarding the policies and practices the PDCs would use in collecting but these requests were denied by the IRS.

Final Observations

I think PDC is a bad idea so I may be a bad person to comment about it.  It will soon come again.  Understanding how it works will help you in advising clients who may have grown complacent as the IRS ability to reach delinquent taxpayers has diminished over the past several years.  While I hope it works, my expectations remain quite low.

Disclosing President Trump’s Tax Returns – An Unconventional Idea

This post originally appeared on the Forbes PT site on February 21, 2017.

We welcome guest bloggers Bryan Camp and Victor Thuronyi. Professor Camp has been our guest before and posted, inter alia, a very popular three part series on Eight Tax Myths – Lessons for Tax Week. Post 1 can be found here, Post II can be found here and Post III can be found here. Professor Camp is the George H. Mahon Professor of Law at Texas Tech. Mr. Thuronyi writes for PT for the first time. Mr. Thuronyi practiced tax law, served in the U.S. Treasury Department, and taught tax law before joining the International Monetary Fund in 1991 where he worked until retirement in 2014 as lead counsel (taxation). He has worked on tax reform in many countries and is the author of Comparative Tax Law (2003) and other writings on tax law.

 Whether you want to see President Trump’s returns or not, the controversy points out to me a couple of things we have gotten right that we ought to celebrate. After abuses of information at the IRS by President Nixon in an attempt by him to make life difficult for his enemies, Congress significantly tightened the disclosure laws in 1976. That legislation has worked. The legislation has worked in part because of the laws enacted but also in part because of the culture it has created at the IRS regarding taxpayer information. Despite a lot of curiosity about President Trump’s returns starting months before his election, the returns have not surfaced. He had no legal duty to disclose them even though precedent of many recent presidential candidates created a cultural expectation of disclosure. I celebrate the success of Congress and the IRS in protecting the returns.

 Recently, Democrats on the Ways and Means Committee tried to use the power of their committee to make public President Trump’s personal income tax returns. This effort failed because they had insufficient votes. Professors Camp and Thuronyi suggest an alternative path to the disclosure of the returns to the Ways and Means Committee or one of the other tax writing committees of Congress. Their approach looks at a little used subsection of the laws governing tax disclosure. Although President Trump did not have a legal duty to disclose his returns and the disclosure laws protect them from disclosure in most circumstances, there may be a way to make them public and one such possibility is the subject of this post. Keith

Lots of folks want to see Donald Trump’s tax returns. Conventional wisdom is that the returns cannot be disclosed unless he consents. That conventional wisdom is based on the general rule contained in 26 U.S.C. §6103(a). The general rule forbids IRS employees (and some folks who receive information from IRS employees) from disclosing “return information.” That is a term of art that means more than just tax returns but basically means anything in the IRS files.

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Section 6103 is a really complex statute, mostly because of the exceptions to the general rule. The exceptions are found in subsections (c) through (o). These exceptions balance a taxpayer’s privacy with the needs of government officers and employees to do their jobs. So the exceptions to the general rule can get quite gnarly.

Several commentators have begun to explore some of the lesser known exceptions to the general rule of nondisclosure. George Yin has a nice op-ed piece that explains one exception to the general rule in §6103: Congress can ask for Trump’s returns. Andy Grewal also explores this idea in a well done post over at the Yale regulation blog. Both posts are worth reading.

Both George and Andy focus on the power of certain Congressional committees and staff to ask for tax returns as part of their oversight function. That power is found in §6103(f)(1) through (f)(4). Democrats have acted on the ideas in George and Andy’s blogs. Stephen Ohlemacher from the AP reports that Democrats on the House Ways and Means Committee tried to get the Committee to ask for Trump’s returns, but were outvoted by Committee Republicans.

The Unconventional Idea

But what if the returns were dumped on the Committee’s lap by an IRS employee without the Committee having made a request? That could happen under the very last paragraph in subsection (f).

Section §6103(f)(5) is a whistleblower exception to the general rule of non-disclosure. It permits disclosure of tax returns to one of the tax-writing committees by “any person who otherwise has or had access to any return or return information under this section” when that person believes that “such return or return information may relate to possible misconduct, maladministration, or taxpayer abuse.”

The plain language of this provision suggests that an IRS employee who otherwise has authorized access to Trump’s tax returns could blow the whistle on Trump if that employee believes Trump’s tax returns related to “possible misconduct” or “possible maladministration.”

The statute does not say whose misconduct or whose maladministration the returns must relate to. An employee’s concern could be that Trump’s extensive business holdings and his well-documented refusal to divest himself of business relationships will create (or has already created) misconduct and maladministration on his part. For example, all of the profits from Trump’s businesses still accrue to his benefit. That means when the federal government leases an entire floor of Trump Tower for $1.5 million, Trump is directly benefitting from that decision.   Or, for example, Trump might sign an executive order barring immigration from certain countries but he might exclude from that order immigration from countries where he or his businesses own property and businesses.

The Problems with the Idea

However, while §6103(f)(5) is a possible avenue for an IRS employee to blow the whistle on Trump, two obstacles make it a tricky one. First, despite the statute’s broad language, the history of its enactment suggests that the language may refer only to the misconduct or maladministration by the IRS or its employees. Second, only an IRS employee who has proper access to return information is permitted to disclose.

  1. Legislative History

Congress enacted §6103(f)(5) in 1998 as part of the IRS Restructuring and Reform Act of 1998 (“RRA”). RRA originated in the House as H.R. 2676 but the provision now codified in §6103(f)(5) was not in the House version. It came from the Senate Finance Committee’s version. You can find all the documents and history of the bill here.

The Senate Finance Committee proposed creating a whistle-blower exception to the general rule of §6103(a). The proposal would have made the exception part of §6103(f)(1) and the proposed statutory language read as follows:

‘‘(B) WHISTLEBLOWER INFORMATION.—Any person who otherwise has or had access to any return or return information under this section may disclose such return or return information to a chairman of a committee referred to in subparagraph (A) or the chief of staff of the Joint Committee of Taxation only if—

(i) the disclosure is for the purpose of alleging an incident of employee misconduct or taxpayer abuse, and

(ii) the chairman of the committee to11 which the disclosure is made (or either chairman in the case of disclosure to the chief of staff) gives prior written approval for the disclosure.’’

The Senate Finance Committee Report explains that “it is appropriate to have the opportunity to receive tax return information directly from whistleblowers.” (p. 105).

Notice, however, how the language chosen by the Senate tax writers limited the authority to blow the whistle. Disclosure was authorized only “for the purpose of alleging an incident of employee misconduct or taxpayer abuse.” The Senate Finance Committee report refers specifically to “IRS employee or taxpayer abuse.”

The Conference Committee expanded the limiting language to the language that became the law. Under the expanded language, disclosure is authorized if the IRS employee making the disclosure believes that the return is related to “possible misconduct, maladministration, or taxpayer abuse.” The expansion, however, seems to stop short of expanding the idea of whose improper conduct is at issue. Under the Senate version, the improper conduct was explicitly linked to IRS employee misconduct or taxpayer abuse. The revised language expanded the kind of improper conduct to include “maladministration.” But whether the revised language expanded the idea to misconduct or maladministration by a government employee other than an IRS employee is unclear. Arguably, however, if the misconduct is relevant to misconduct of the sort that a Congressional committee might investigate, then the broad language of the statute could cover it.

2. Whistleblower Must Have Access

Even if one reads §6103(f)(5) as authorizing an IRS employee to blow the whistle on a non-IRS government employee, one large obstacle remains. Section 6103(f)(5) only applies when the IRS employee making the disclosure has authorized “access” to the return. This would mean that only the relatively narrow group of IRS employees who are authorized to view the returns for audit or other purposes would be eligible whistleblowers. That brings us back to Trump’s claim that he is under audit.  If he is telling the truth about that, then there are certainly some IRS employees who have legitimate access to at least the returns being audited.

In addition, any other person, such as an employee of a state taxing agency, who has properly received the returns from the IRS pursuant to the exceptions listed in §6103(a)(3) would also have proper access. We do not explore the legal position for this group, however, since it would involve delving into potential state law prohibitions on their action.

Congress has enacted a number of statutes that make willful violation of the disclosure rules a crime. First up is §7213 which imposes a fine up to $5,000, and up to five years imprisonment for any willful violation of §6103. See e.g. United States v. Richey, 924 F.2d 857 (9th Cir. 1991).   In the criminal context, however, the Supreme Court has instructed that a good-faith misunderstanding of the law or a good-faith belief that one is not violating the law negates willfulness, whether or not the claimed belief or misunderstanding is objectively reasonable. Cheek v. U.S. 498 U.S. 192 (1991).

Second, 18 U.S.C. § 1030(a)(2) makes the unauthorized access of government computers a felony. This provision includes the unauthorized access of returns or return information in government computer files.

Third, in the RRA, Congress created 26 U.S.C. §7213A to specifically make the unauthorized inspection of returns or return information, whether in paper or computer files, a misdemeanor. See Pub. L. No. 105-206, 112 Stat. 711 (1998).

Conclusion

We have never before had a President so vulnerable to conflicts of interest and, at the same time, so callous about his governing duties and so careless of the law. This potent combination requires checks, it requires balances. Checks and balances are what have enabled this country to thrive for over 200 years. A review of Trump’s tax returns is but a small part of what is necessary to check on his behavior. If the Congress does not have the political will to use its powers, there remains a possibility that a whistleblower from the IRS or a State agency could force the issue.

 

Preparer “Doctors” the Return Adding Phantom Income: Court Sustains Preparer Penalties

Tax return preparers have heightened requirements when preparing returns claiming many refundable credits. While the IRS lost the battle over regulating unlicensed preparers, it does have tools to examine and sanction preparers who violate those rules. There have been very few opinions considering whether a preparer’s conduct justifies the imposition of civil penalties. Last week in Foxx v US the Court of Federal Claims held that a preparer was subject to a civil penalty under Section 6694(b) for his willful or reckless conduct relating to his failure to make reasonable inquiries into income from taxpayer’s purported auto-detailing business. The IRS claimed that the taxpayer did not in fact earn the income in question. The Foxx case presents the what frequent guest poster Carl Smith has referred in a guest post to as the topsy-turvy world of earned income tax credit (EITC) cases because the creation of the phantom income fueled a refundable EITC that exceeded the taxpayer’s income and self-employment tax liability.

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George Foxx came to the attention of the IRS after it audited the tax return of Shakeena Bryant. Bryant had claimed an EITC; almost all of the earned income on the return was from an auto-detailing business she reported on Schedule C. Foxx referred to himself as the tax doctor and claimed to have 37 years of tax return prep experience. Bryant went to the tax doctor with a friend of hers, Herman James. On audit of Bryant’s return, the IRS disallowed the credit. During the audit, she agreed that she did not have the income necessary to justify her claiming the credit. In correspondence, Bryant claimed that she was instructed by Foxx to report the income to justify the refund.

IRS then examined Dr. Foxx and assessed a $5,000 penalty under Section 6694 for his willful or reckless conduct in preparing the return (note there is a separate $500 penalty under Section 6695(g) for violating the due diligence rules; that penalty was not at issue in the case). After an administrative appeal of his penalty IRS reduced it to $2500. Foxx paid and sued for refund.

The government deposed Bryant’s friend (James) who accompanied her to Dr. Foxx when the Tax Doctor prepared her return.

The case on the surface turned on whether the preparer George Foxx 1) facilitated the improper claiming of the credit by instructing the taxpayer how to goose the credit and make it look legitimate by applying for a business license even in the absence of the actual business or 2) prepared the return based on what Bryant told him about her business.

A bad fact for the Tax Doctor in this case was that James on deposition supported Bryant’s version of the facts. Both Bryant and James stated that she obtained a business license the same day the return was prepared pursuant to Dr. Foxx’s instruction. James also stated that Dr. Foxx “explained that such a license would allow him to obtain more money for Ms. Bryant, and Dr. Foxx, not Ms. Bryant, created the false business income that appeared on Ms. Bryant’s tax return.”

According to the opinion, Foxx clamed that in preparing the return he relied upon Bryant’s business license and two pages of his notes that outlined expenses associated with the business.

What was potentially a he said/they said case evolved into the court concluding that it did not matter which version was true. Even if Bryant did tell the preparer about her income the court concluded that Foxx had an affirmative obligation under the specific EITC due diligence regulations to dig deeper:

Dr. Foxx argued before the IRS that his reliance on Ms. Bryant’s alleged statements regarding her business was reasonable because Ms. Bryant otherwise would have only earned approximately $15 in 2007 based on the W-2 she provided to Dr. Foxx. Such an argument is misplaced; Ms. Bryant’s financial situation did not relieve Dr. Foxx of his obligation to make reasonable inquiries into any auto detailing business purportedly conducted by Ms. Bryant after she did not provide adequate documentation. His failure to do so was an intentional or reckless disregard of relevant Treasury Regulations [referring to the due diligence regulations under Section 6695]

Schedule C and Compliance Generally

As the Foxx case illustrates, the EITC creates the odd incentive for the creation of phantom income that could fuel a tax refund. That phantom income could also create a record of social security benefits that could generate Social Security benefits.

While noncompliance with the EITC generates significant attention, the absence of information reporting that ties much income to self-employed taxpayers contributes to those taxpayers in general comprising the largest source of the individual tax gap. EITC noncompliance among self-employed taxpayers is a small but significant part of the tax gap that is associated with self-employed taxpayers. Despite the EITC comprising a small portion of the tax compliance problem among the self-employed, there are special due diligence obligations imposed on preparers who prepare EITC returns with Schedule C’s that do not apply to other Schedule C returns.

On the IRS’s EITC web page for professionals it has a special training section discussing Schedule C. The training states that preparers “generally can rely on the taxpayers’ representations, but EITC due diligence requires the paid preparer to take additional steps to determine that the net self-employment income used to calculate the amount of or eligibility for EITC is correct and complete.”

IRS has on its EITC due diligence web site a series of scenarios discussing what it believes are examples of when preparers need to take additional steps. One of the scenarios involves a self-employed housecleaner who comes to a preparer claiming exactly $12,000 in earnings with no records and no expenses. A similar example is in the regulations. For the house-cleaner with the rounded off income figures and no expenses the IRS advice states that a preparer should “probably not” prepare the return in the absence of at least a written record of expenses and earnings, though opens the door a bit if the taxpayer “can reasonably reconstruct” the earnings and expenses. To that end the advice suggests that the preparer should ask how much she charges per house, as well questions relating to how many houses she cleaned on average per week and probe as to the reason for the lack of expenses (e.g., the homeowners provided all supplies).

Back to Foxx

One does not need to have a suggestion that a preparer has encouraged the fabrication of phantom income to generate preparer penalties. A cautious reading of the Foxx opinion is when preparing a return with an EITC based on self-employment income the preparer should  require documentary evidence supporting the amount claimed to have been earned and any expenses that are incurred. In the absence of records (a sure bet for many) the preparer should document and retain an explanation as to how he came to the net earnings, tying conclusions to specific information that the client has provided. For a taxpayer with little in the way of documents, it would be a good idea to have the taxpayer in writing affirm the manner that the preparer computed a business’ net earnings and state that the facts that the preparer is relying on are accurate to the best of the taxpayer’s recollection. Absent that the preparer opens himself up to a charge that he has failed to make “reasonable inquiries” in the presence of incomplete information (one of the requirements under the due diligence regulations).

TaxJazz: The Tax Literacy Project

We welcome first time guest blogger Marjorie Kornhauser.  Professor Kornhauser is the John E Koerner Professor of Law at Tulane Law School.  She has created a tax literacy program.  Like almost all tax practitioners, we occasionally get asked to speak at various functions where we play the role of tax expert to an audience that consists of individuals whose lives do not revolve around tax, but we are not the sole targeted users of project.  The material that she has created can assist anyone called to present in such a setting.  If we can teach more people about the tax system, maybe they will engage in a way that makes the system work better.

As we celebrate President’s Day and think back to George Washington who spoke of taxes in his famous farewell address and Abraham Lincoln who created the first income tax, today is the perfect day to contemplate tax education and what we should all know as citizens. The Washington Post just reported on her project.  The article in the Post provides greater detail than this post about the information available through the project for those who find this of interest or want to use the materials in an upcoming presentation.  Professor Kornhauser has put a lot of work into engaging with those who do not normally get information about how the tax system works.  Congratulations to her on pulling this project together.  Keith

In 2009 an H & R Block survey concluded that most American know so little about tax that they would flunk “Tax 101.” They didn’t know the difference between a deduction and a credit. Many didn’t even know the amount of taxes they owed. This tax ignorance—which still exists today—is not only widespread but dangerous. Not only does it create feelings of frustration, but it also engenders feelings of unfairness among taxpayers that can undermine the legitimacy of tax laws (and voluntary compliance). Tax illiteracy also constricts congressional ability to craft coherent tax policies to help solve critical problems in numerous areas such as education, energy, health and housing.

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Despite the fact that taxation is a critical component of both personal and national finances, financial literacy programs pay little or no attention to taxation. Moreover, most web sites and written materials about tax are geared to either sophisticated readers and/or to filling out tax returns. There are few, if any, resources available for ordinary people to learn about tax and tax policy. They need this knowledge in order to participate in an informed way in a rational debate about the future of American tax policy. Such a debate would facilitate tax laws that facilitate solutions to national problems rather than obstruct them.

Four years ago I started TaxJazz: The Tax Literacy Project to fill the huge tax knowledge gap. I began by offering real-time activities to schools and community groups. These activities have been led either by me, teachers, or Tulane Law Students trained by me. This February, I extended the reach of TaxJazz by launching its webpage TaxJazz.

The materials I have created to date address fundamental tax issues. Collectively titled Taxes, Society, and Fairness, these materials form a curricular unit that provides essential information (including vocabulary) about three main topics:

  1. Why we have taxes;
  2. Basic limitations on the taxing power;
  3. Distributive justice in the context of taxation.

Distributive justice is the heart of this material. In the course of analyzing the parameters of tax the materials examine the components of tax burdens (tax bases and tax rates) and familiarize the reader with essential concepts and vocabulary, such as the difference between marginal and effective tax rates.

Each topic contains an exercise that allows readers/users to grapple with the issues. The final exercise, for example, involves a city council which is considering several taxes in order to raise money for pressing infrastructure repairs. The readers (or for example, students in a classroom) role-play. First they act as associates in a consulting firm. Their assignment is to advise the city council as to which tax to choose. After they have given their advice, they then assume the roles of councilors who debate and vote on the tax proposals.

The materials do not guide the user to one “right” answer as to distributive justice (since there isn’t one). Rather, they help a user reach a personalized opinion based on information.

In the four years of its existence, TaxJazz and its Taxes, Society, and Fairness curricular unit has already been used by over 350 people between the ages of 12 and 80 in a variety of different settings including high schools, a city recreation department’s after-school program, and a community senior center.

I have just launched the TaxJazz website. Now any individual with a computer can easily access its non-partisan, non-technical tax information to help people participate in discussions about tax policy and problems facing the nation. So far, TaxJazz deals only with the basic foundational issues in Taxes, Society, and Fairness. It will add materials on particular tax issues and provisions that affect large numbers of people, such as education, housing, and health. Additionally, it plans to offer training for teachers, community leaders, and others who would like to lead discussions about taxation. Eventually, the site will provide all this information in a variety of formats ranging from traditional text-based information to videos and games.

Lao Tzu said, “A journey of a thousand miles begins with the first step.” The first step to moving the United States towards a better tax system is tax literacy. In a democracy, active voters influence their elected officials, but officials also influence the voters. Tax literacy gives the voting public the ability to ask officials and candidates informed questions and to demand substantive answers. Such an informed public can force a rational substantive debate about taxes rather than a rhetorical one.