Eight Tax Myths – Lessons for Tax Week Part III

We welcome back guest blogger Bryan Camp for part three of his three part series dispelling tax myths. In Part III he covers myths 7 and 8.  Post 1 can be found here and Post II can be found here. Keith

This post originally appeared on the Forbes PT site on April 15, 2015.

7. The IRS Abuses Taxpayers

Some myths are based on a kernel of truth and this is one of them. But the abuse is not what you think it is.

Taxpayer abuse happens when a taxpayer is not treated fairly according to his or her circumstances. The key to abuse is the idea of discretion.  On the one hand, if there is no discretion in applying rules, then some folks will inevitably be abused because their circumstances were not foreseen by those who wrote the rule.  On the other hand, giving someone discretion to bend the rules also results in abuse because the humans exercising discretion will inevitably make poor judgments in exercising the discretion.  That’s what it means to be human: to make mistakes.

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Here’s a simple example: let’s say we want to give “equal” access to justice and so we have a rule that one must climb 39 steps to reach the courthouse door and file suit.  If you don’t climb those 39 steps, you cannot obtain justice.  If that rule applies to everyone “equally” so that there are no exceptions, then the rule abuses those folks who cannot climb the 39 steps because of some disability.  But if we station a person at the bottom to decide who must climb the 39 steps and who need not do so, we now create opportunities for abuse by that person.  We may put rules in effect by which that person must exercise the discretion but, at bottom, it’s a case-by-case determination.

So it is with the IRS. Both types of abuse exist but it is the second kind that most of us associate with taxpayer abuse.  For example, the gist of the so-called “targeting scandal” is that IRS employees had discretion on how to approve applications for exemptions and abused that discretion in giving extra scrutiny to applications from conservative organizations.  The mythology being built on top of this story is impressive, but my purpose here is to simply note the example.  Interested readers can find a lucid and geekily comprehensive take on the matter by Professor Philip Hackney of LSU.

This abuse of discretion certainly exists because IRS employees often have discretion to decide what actions to take on a taxpayer account, and so if follows that IRS employees sometimes abuse that discretion. You can even find court cases on this, where a court—usually the U.S. Tax Court—finds that an IRS employee abused discretion.  For example, taxpayers generally cannot ask for forgiveness of their tax liabilities, but there are exceptions and certain IRS employees have discretion to compromise the tax liability—i.e. forgive some or all of it—in some situations.  In a case called Szekely v. Commissioner, heard by the Tax Court in 2013, Mr. Szekely asked to compromise his tax debt and the IRS employee reviewing his request refused. The Tax Court ruled that the IRS employee did not treat Mr. Szekely right because the employee rejected the request a mere one day after Mr. Szekely missed a deadline to provide additional information.  Under the circumstances of Mr. Szekely’s situation—detailed in the Court opinion—that refusal was an abuse of discretion. Mr. Szekely got a “do-over.”

While this second idea of abuse—IRS employees abusing discretion—is sometimes true, it is a myth that such abuse is widespread. One has to go back to 1997 to even find allegations of widespread taxpayer abuse.  In was then that Senators Roth and Grassley held hearings—one set in September 1997 and one set in April 1998—hearings for which they had spent over a year carefully gathering the stories of this kind of supposed IRS abuse.  The hearings were high political theater and, as with most theater, were mostly fictional: the dramatic allegations made from behind face screens and voice screens turned out to be almost all false, according to later independent investigations from the General Accounting Office and the Treasury Inspector General’s office.

If you really want a juicy IRS “scandal” you need to go back to the 1940’s, as I have explained in gory detail elsewhere. That scandal resulted in the removal or resignation an extraordinary number of high-level officials, including the Assistant Commissioner in Charge of Operations, the Chief Counsel, the Assistant Attorney General in Charge of the Tax Division of the Department of Justice, and 9 high-level agency employees, 3 of whom were also criminally prosecuted.

In contrast, the 1997 and 1998 so-called scandals resulted in no criminal prosecutions, no forced resignations, no removal from office. The sole individual implicated in the congressional hearings was a mid-level manager.  And yet, of the 20 allegations against this individual—described in an 80 page narrative report with 2,200 pages of attachments reflecting interviews with 140 people, including every revenue officer and manager in the this individual’s office—only 6 violations of policy were substantiated, none involving abuse of specific taxpayers.

And the current “tea party” scandal? There have been two forced resignations and no prosecutions.

The clear-eyed view of our tax system is to see how it is effectively administered by computers, not humans.  Once the myth that humans run the show is exposed, one can more easily see the devastating effects of budget cuts as I have elsewhere blogged. And so we move to Myth #8.

8. The IRS is Run by Humans

Lots of folks work at the IRS. Even after five years of punitive budget cuts, the IRS still employs some 80,000 workers.  It is true that the IRS budget is mostly spent on personnel costs.  It is true that the face of the IRS is human, currently the Commissioner John Koskinen, who appears as able a Commissioner as any since the redoubtable George S. Boutwell held the position in 1862.

But behind those employees, behind that elfin face of Koskinen, lies the heart of our tax administration system: computers. The story of tax administration since WWII is the story of increased reliance on automation, on computers.  And computers run on rules.  Strict rules. The basic job of the humans at the IRS is actually to prevent the abuse that results from rigid application of rules.

The myth that humans run the IRS, that the fiendishly complex Tax Code (not IRS Code!) created by Congress is administered by actual human beings, obscures both what is good and what is not good about the current state of tax administration. Let’s look at two examples.

First, on the tax assessment side, we have already seen in Myth #4 how IRS computers rule the returns processing function. If one in a series of computer filters flags a return, the IRS will not process that return unless, and until, an IRS employee decides to accept it.  Put another way, it is the computer that decides whether to assess the tax reported on a return.  It takes a human to override the computer’s decision.  The good part about this is that the computers can process millions of returns far more efficiently than humans.  The bad part is that if the computer makes an error, the risk falls entirely on the taxpayer because it is up to the taxpayer to see the error and find some human IRS employee to fix it.

Similarly, the IRS has other computer systems that relentlessly propose increases to tax liabilities, increases that will be assessed unless and until a human IRS employee decides to override the decision of the computer. One example is the Automated Underreporter system.  It compares the W-2’s or 1099’s filed by third parties to what the taxpayer reports on the Form 1040.  If the numbers from the third party information returns are more than what the taxpayer has reported on his or her return, the computers follow the rule that the numbers on the W-2’s or 1090’s are correct.  The computers (not humans) send out a notice to the taxpayer.  And if the taxpayer does not respond to the computer-sent proposal in the right amount of time and to the right office with (often) the right-sized envelope, the computers (not humans) automatically print out the increased tax for assessment.  No human being ever reviews these cases before assessment unless and until there is a recognized taxpayer response to stop the computers.  The IRS employs a similarly automated system for what it calls “correspondence exams.”  Here is how the National Taxpayer Advocate described that system:

Once the IRS engages the batch system, cases move through the examination process automatically. Each step in the process has a pre-established period programmed into the system.  Files are not created or examiners assigned to the cases until the IRS receives and controls a taxpayer‘s correspondence.  If a taxpayer fails to furnish the requests documentation precisely within the prescribed period, the case automatically moves to the next phase in the process.  … Because the batch system automatically processes a case from its creation through the issuance of a Statutory Notice of Deficiency and subsequent closing, the IRS has effectively eliminated the need for human involvement in every case in which a taxpayer does not reply in a timely fashion.

 

We see the same model of computer action on the collection side, in the Automated Collection System. This is the computer system that collects unpaid taxes.  The computer, not humans, matches the W-2 information filed by employers and the Form 1098 information filed by banks to identify where taxpayers work or have assets.  Then the computer, not a human, sends out a Notice of Levy to grab wages or grab a taxpayer’s bank account.  It is the computer, not a human that will file a Notice of Federal Tax Lien (NFTL), which not only makes it difficult for taxpayers to sell their homes but also results in a major hit to the taxpayer’s credit rating.  If the taxpayer wants to undo any of these actions, or if the taxpayer believes the actions were abusive or unfair, the taxpayer must find a human IRS employee and persuade that employee to use discretion to ameliorate the damage.

Just look at the volume of levies and NFTLs in FY14: over 2 million levies and some 535,000 NFTLs.  That’s the work of computers, not humans.  And while the computers might be shutdown if the IRS shuts down, they will keep on working, even if employees must be furloughed. So finding the human to override the computer becomes increasingly difficult.

The clear-eyed view of our tax system is to see how it is effectively administered by computers, not humans. Once the myth that humans run the show is exposed, one can more easily see the devastating effects of budget cuts.  First, fewer and less trained employees means that taxpayer will be increasingly unable to undo the mistakes that computers will inevitably make.  Second, the less money the IRS has to hire and train competent employees, the more reliant tax administration will be on computers.  One sees this in the current IRS plea for expanded math-error authority.  The problem with this expanded authority, as Keith Fogg promises to explain in his typically thoughtful way, is that it will simply shift more work current done by humans to computers, creating more room for computers to make automatic initial decisions against taxpayers that then can only be undone by humans if and when the taxpayer responds.

This concludes my series on myths about tax and tax administration. I have little doubt most of them will persist.  That does not trouble me.  As a teacher, my job is to introduce curious minds to new ideas and give those who are interested tools to pursue their interests further.  I hope at least to have accomplished that.

 

 

Eight Tax Myths – Lessons for Tax Week Part II

We welcome back guest blogger Bryan Camp for part two of his three part series dispelling tax myths. Yesterday he covered myths 1, 2 and 3. In Part II he covers myths 4, 5 and 6. Keith

This post originally appeared on the Forbes PT site on April 14, 2015.

4. The IRS Exists

People commonly refer to the IRS as if it were a sentient being, like the Borg from Star Trek. That’s part of the charm when Ted Cruz refers to the “IRS Code.” Double myth-making: the evil Borg writes the tax laws. But more sensible people also fall into the shorthand. Heck, I do it too. Go to yesterday’s post in Myth #3 where I wrote that the IRS “could choose to instead file suit in federal court.” As if the IRS can “choose” to do anything! The anthropomorphic metaphor is so commonplace and convenient that it leads us into mythology.

In truth, the IRS does not exist either in fact or in law. As a matter of fact there are just a bunch of people, organized into offices, each with assigned tasks, assigned functions, and each placed into a hierarchy of review. In other words, it’s a bureaucracy. And it’s what I get paid to teach, to study, to write on and to think about. Lucky me. So it’s the people working in the agency, not some Marvel Comics SuperBeing, who do stuff — bad stuff, good stuff, whatever. It is not the IRS that allegedly gave extra scrutiny to conservative organizations that sought to be exempt from paying tax on their incomes. It was individuals in Cincinnati, or in Washington D.C. who allegedly did that. Having working the bowels of the bureaucracy for eight years, I just snort with derision when I read yet another conspiracy theory about “the IRS.” The whole tax-exempt so-called scandal (more on that tomorrow in Myth #7) is much more about office politics—bickering between field employees and the National Office employees—than partisan politics.

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As a matter of law, what we now call the IRS grew out of that same seismic 1862 revenue legislation I discussed in yesterday’s posts. It was at that time that Congress created the position of “Commissioner of Internal Revenue” and made that person the head of an office within the Treasury Department “to be called the office of the Commissioner of Internal Revenue.” The first Commissioner was the indefatigable George S. Boutwell, who took office in On July 17, 1862. He started with just three clerks but by the end of 1862 he had ramped up operations to 3,882 employees, all but sixty scattered throughout the non-rebelling states. The guy was an operator. As these numbers suggest, and as I have written in boring academic articles, tax administration was in large part a field operation involving what one member of Congress denounced as an “army” of tax collectors and another colorfully termed “pygmies.” Over time, this army of pygmies became known as the Bureau of Internal Revenue (BIR). The name changed to the Internal Revenue Service only some 90 years later, as part of a reorganization in 1952 following a real scandal. More on that tomorrow, in Myth #7.

If you go read the tax statutes, you will see something curious: they are written as if one single individual—the Secretary of the Treasury—is responsible for the entire tax system. For example, here is the foundational language Congress uses to empower the collection of tax: “The Secretary is authorized and required to make the inquiries, determinations, and assessments of all taxes…imposed by this title.” The tax statutes do not place duties or obligations or give directions to the IRS and rarely to the Commissioner. Everything is to be done by one individual: “the Secretary.” And so that is where the chain of command starts, with various duties delegated down from the Secretary to the Commissioner to various other offices within the agency. And so grows the myth: the IRS exists.

5. Returns are Rarely Reviewed

USA Today recently told its readers that “the audit rate, the percentage of individuals’ tax returns IRS revenue agents examined either in person or via correspondence, fell to 0.86% last year.”

That’s a true statement as far as it goes, but it does not go very far. It is generally combined with myth #3 (from yesterday) about self-assessment to create a myth that taxpayer returns are rarely reviewed.

In fact, all returns—yep, 100%—are reviewed, scrutinized, inspected, verified, analyzed, checked, checked out, checked over, investigated, looked over, probed, and otherwise studied, before the tax liability is assessed. And remember, an IRS employee makes the assessment not the taxpayer. Most of the review comes during what is known as “returns processing.” While this review is not as extensive as a full-scale audit, it is wrong to think that returns processing review rubber stamps whatever the heck taxpayers see fit to report on their tax forms.

The processing of returns subjects every return to various computer filters to decide whether that return is likely enough to be correct to be accepted as filed. If the computer flags the return, it gets kicked out and does not get processed through to assessment until passing through additional verification procedures. Nina Olson, the National Taxpayer Advocate makes this point nicely in describing the arduous journey that what she terms “every poor little refund return” must take before the IRS accepts it. During the 2013 filing season, says Ms. Olson, 12.3 million returns were kicked out of the processing flow because of potential errors identified during processing—meaning they were sent to “error resolution,” an office that requires taxpayers to present additional information to get their returns processed. All refund returns are run through an Electronic Fraud Detection System and suspicious returns selected by the computers are held until the income and IRS employees can verify withholding.

These automatic filters are by no means perfect. The latest hot issue is that the IRS got scammed to the tune of some $5.8 billion dollars by identity thieves. More on that in Myth #6. Of course, what is not as often noticed is that the filters did catch and stop some $24 billion in fraudulent refund claims.

Returns claiming certain types of credits are subjected to additional review over and above the series of computer filters. According to Ms. Olson, during the 2103 filing season some 358,000 Earned Income Tax Credit returns and 90 percent of returns submitting claims for the adoption credit were kicked out the regular processing stream by computers and given individualized review by IRS employees.

Ms. Olson takes a dim view of how the IRS processes returns because it holds up the refund process for many honest taxpayers. But whether one views the current process as benign or malignant, the fact remains that the process does not simply “accept” returns as filed and blindly or mechanically “assess” what the taxpayer reports.

6. The IRS Wastes Money on Erroneous Refunds

I love my yearly tax refund. I know I am not supposed to, but I do. Theorists argue that my refund represents an interest-free loan to the government and I am supposed to resent that, for reasons grounded in the obsessive individualism of our culture. But even accepting the argument’s premise, the value to me of that yearly manifestation of my forced savings outweighs the value of the interest I would theoretically earn in my checking account. I don’t worry, I be happy.

I am not alone. In FY2013, the IRS made lots of folks happy, sending out some $313 billion income tax refunds to individual taxpayers on gross collections of $1.564 trillion. Some folks get extra happy because their refunds were in error, either because of an IRS mistake or because their tax refund scam worked. No one knows the exact dollar amount of erroneous refunds issued, but the Government Accountability Office recently accepted $5.8 billion as a reasonable guess just as to the amount issued in FY2013 on account of identity theft.

Some folks use these numbers to propagate a myth that the IRS commits significant error in making refunds. Similar to the myth of the IRS Code, this is myth that seeks to fix the blame and not fix the problem.

For example, I was watching IRS Commissioner John Koskinen testify before the House Appropriations Subcommittee on Financial Services on March 18, 2015. There, Representative Tom Graves (R-Ga.) asserted that the amount of erroneous refunds was significant because it was “more than half, I guess, of your entire agency’s budget.” Graves also asserted that the IRS issued the $5.8 billion “knowing that $5.8 billion could go to defense, it could go to so many other needs within our country right now….but instead criminals all across the country, if not across the world, are receiving these tax refunds.” Using these comparisons, Graves was seriously concerned that the IRS was screwing up big time. Notice here the use of Myth #4: an entity called the IRS “knew” the erroneous refunds could go to other purposes.

Graves’ office was so proud of his performance that they posted his part of the hearing on www.peachpundit.com. They should not have. The excerpt makes Graves look like a clueless git.

First, Grave’s claim that the money erroneously refunded could have gone to some other program is fatuous. There is no direct linkage between money collected and money spent. Congress first must budget for an expense and then it must appropriate the money for the expense. Once it takes those two actions, the executive branch has to spend the money, and if there is not enough money to spend, the executive branch must borrow the money, again subject to broad controls by…Congress itself. It’s not like someone from the IRS says “hey, we found some extra money here!” and runs over to Congress with a check for Congress to immediately spend on those “other needs,” which—speaking of wasting taxpayer dollars—no doubt include many new bridges to nowhere. You would think Graves would understand that basic budget process, him being on the House Appropriations Committee and all.

Second, and more importantly, this excerpt shows that Graves sucks at numbers, which is pretty sad given his committee appointment. His comparison of the erroneous refund rate to the agency’s budget is nonsensical. As best as I can make out, he is suggesting that the agency gave away half of the money the Congress appropriated to it. Really? Is he really trying to say something like “hey, we gave you a budget of more than $10 billion and you gave half of it away”? If so, that’s really stupid because at the same time the IRS was erroneously refunding $5.2 billion it was properly collecting $1.56 trillion in individual income taxes alone (i.e. not counting corporate income taxes, excise taxes, “death” taxes, or employment taxes). So in Grave’s own terms, the agency was not giving away half its budget; it was collecting some 156 times its budget. If you really want to compare dollars collected to IRS budget, study after study shows that every additional dollar allocated the IRS results in multiple additional tax dollars collected. As the National Taxpayer Advocate reported in 2013: ““For virtually every other spending program, a dollar spent is just that – it increases the deficit by one dollar. But a dollar spent on the IRS generates substantially more than one dollar in return – it reduces the budget deficit.”

A more reasonable approach would start with the question “is the IRS collecting what it should?” I figure that $5.8 billion is about 0.04% of the $1.56 trillion properly collected. So one could as well say that the IRS properly collected 99.96% of what it would have collected if it had not sent out these refunds. Yes, $5.8 billion is a lot of moola, but it’s a 0.04% drop in the tax collections bucket.

Another reasonable approach would be to ask “is the IRS refunding what is should”? That is, measure IRS performance here by comparing erroneous refunds to all refunds made. In FY13 the IRS issued $314 billion in total refunds. I figure that the $5.8 billion in erroneous refunds is about 1.8% of all refunds made. So Graves is pounding on the IRS for correctly refunding 98% of all refunds instead of….what? 100%? Even measuring the IRS performance against what a perfect agency would do is far more reasonable than the budget baseline Graves hurls around.

By almost any measure, the IRS does a great job in getting the right refund to the right taxpayer in a timely fashion. But errors happen. Worse, given the huge amounts involved, even small error rates add up to large numbers. It remains true that the $5.8 is a large number and even a blemish can become cancerous, so the IRS management is appropriately concerned about this situation. It has diverted more than 3,000 employees out of its increasingly small workforce from other tasks to deal with the problem. But in the hearings I watched, Graves is so set on perpetuating the myth of IRS screw-up that he completely ignores the suggestions patiently and repeatedly offered by Commissioner Koskinen on how to fix the problem.

Tomorrow: Myth #7 (The IRS Abuses Taxpayers) and Myth #8 (The IRS is Run by Humans).

Eight Tax Myths – Lessons for Tax Week

We welcome guest blogger Bryan Camp. Bryan is the George H. Mahon Professor of Law at Texas Tech School of Law. Bryan is a prolific and engaging writer. We worked together at the Office of Chief Counsel, IRS for several years where I had the pleasure of watching fellow bureaucrats react to his wonky writing. This is the first of a three part series dispelling common myths about taxes and the tax system. Perfect reading for the week we perhaps think most about the American tax system. Keith

This post originally appeared on the Forbes PT site on April 13, 2015.

The Tax Code is a puzzle. Whether one views it as an engaging enigma or a ridiculous riddle, everyone has to deal with it and with the agency that administers it: the IRS. And an IRS letter in your mailbox cannot help but bring feelings of dread, even if the contents turn out to be a refund check. It is not surprising then, to find more than a few myths about the income tax and the IRS in our popular and political culture. Here are some of them.

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1. The Income Tax Started in 1913.

One common myth is that the income tax started in 1913, after passage of the 16th Amendment to the Constitution. For example, Judge Boasberg, a highly educated federal judge in the prestigious U.S. District for the District of Columbia, recently wrote in one of his opinions: “…the casual student of history knows that the Sixteenth Amendment authorizing the modern federal income tax was not ratified until 1913.”

Forget 1913. The watershed year for the modern income tax in the United States was 1862. That was when, in desperate need of revenue to fund the Civil War, Congress passed a revenue act of unprecedented scope and complexity. Before then, the federal government had raised its revenue from external sources via customs duties, or tariffs, on imports. But the Revenue Act of 1862 did not just toy with tariffs. It created a vast number of brand-spanking new taxes imposed on those within the United States, thus generating “internal revenue.” Most of the taxes were excise taxes—taxes on the production or consumption of myriad articles of commerce, everything from candles to cloth to pickles. Birthed along with this welter of new excise taxes, however, was a new kind of tax called the income duty. It was just the runt of this litter; private compilations of the tax laws published over the next several years did not even have “income” in their titles. Few foresaw how big that runt would grow or how much of the 1862 statutory language would still be operative over 150 years later, embedded in the current Tax Code.

This newfangled income duty was so successful in raising revenue that Congress kept renewing it until 1872, seven years after the Civil War ended. And Congress revived it again in 1894. It was then opponents raised a question about whether a tax on income was a “direct tax” within the meaning of the U.S. Constitution. If it was, then Congress would have to apportion the revenue among the states, a political death blow to any tax. In 1894 the Supreme Court dealt the blow in Pollock v. Farmer’s Loan, where it decided that a tax on income received from rental property was a “direct tax.” Note this did not make the tax unconstitutional, it just made the tax unconstitutional without apportionment.

That is what the 16th Amendment was all about: removing the apportionment requirement, not authorizing the tax itself. Even before the 16th Amendment Congress doggedly kept writing income tax laws. In 1909 Congress started taxing the business income of corporations, and the Supreme Court held that was not a direct tax and so was not subject to apportionment. In 1912, based on the success of the 1909 legislation, the House Ways and Means Committee approved a draft bill to impose a similar income tax on the business income of individuals. The Committee Report contains a lengthy analysis of why that version of an income tax would survive a constitutional challenge. The passage of the 16th Amendment, however, obviated the need for such legerdemain and so instead of a new “excise” tax, Congress simply tacked an income tax provision onto the 1913 Underwood Tariff Act, much as it had tacked the income duty on the revenue bill back in 1862.

2. The “IRS Code.”

Another common myth is about something called the “IRS Code.” For example, Ted Cruz routinely claims “there are more words in the IRS Code than in the Bible.” The line gets a lot of laughs even though the comparison makes little sense. The Spanish Inquisition, Crusades, and French wars of religion involving the Huguenots should be proof enough that fewer words bring little advantage when it comes to clarity, fairness, or social acceptance.

There is no “IRS Code.” Since 1926 the federal tax laws have been arranged by subject matter in a compendium called the United State Code, or “US Code.” Each subject gets its own title number. So, for example, you can find all the bankruptcy statutes collected in Title 11, also known separately as the “Bankruptcy Code.” And you find all the federal tax laws compiled in Title 26, also known separately as the “Internal Revenue Code” or “IRC” or “Tax Code.” All of those are quite acceptable shorthands. But “IRS Code” makes no sense. The IRS is the agency that administers the Tax Code. It is stuck with the same tax laws that you and I are stuck with, laws enacted by Congress and signed by the President.

So why does Cruz use the term “IRS Code”? After all, he went to Harvard Law School. He knows better. Pronouncing “I-R-S Code” also takes more syllables than saying “Tax Code.” So it’s not a short cut.

The most likely reason is political. The term is a convenient mash-up that attempts to associate responsibility for the tax laws to the agency that administers them. Saying “IRS Code” implies that the IRS is responsible for the tax laws, that the IRS wrote the words of the statutes. Hate one, hate both. By using the term, Cruz can blame the agency for all the words in the Code when the reality is that Congress—where Cruz sometimes works—is responsible for the verbiage, however excessive one believes it to be.

Other politicians are more honest about the matter. For example, in a February 3, 2015, Senate Finance hearing, Senator Orrin Hatch candidly acknowledged to IRS Commissioner John Koskinen (during minute 42 of the hearing video) that “the length of the tax laws have more than tripled since 1975…We should not blame you for this. Congress is the one that keeps adding to your growing responsibilities.”

So, please, the next time you hear the term “IRS Code,” ask yourself whether the person using that term is being ignorant or manipulative. Those are the only two reasons for using the term.

3. Income Taxes are Self-Assessed.

One of the most common myths is that our tax system is based on self-assessment. Not to pick on the good Judge Boasberg, whom we met in looking at the 1913 myth, but in that same court opinion, he buys into this myth as well, declaring “our system is basically one of self-assessment,” a phrase he actually takes from this IRS regulation! Heck, if the IRS says so, why is this a myth? Well, the very next sentence of the regulation shows why: it explains that each taxpayer “is required to file a prescribed form of return which shows the facts upon which tax liability may be determined and assessed.” And who does that assessment? Why, the IRS.

Our system is not one of “self-assessment.” I don’t care who is propagating this myth, whether it’s a judge, a politician, or the taxing agency itself. They are just wrong. Wrong as a matter of law. Wrong as a matter of fact.

As a matter of law, our system is not one of self-assessment. It is a system of self-reporting only. Section 6201 of the Tax Code tells us who makes the assessment and it does not say “the taxpayer shall assess” or “the taxpayer shall self-assess.” It says, “the Secretary shall assess.” Section 6203 explains that the assessment “shall be made by recording the liability of the taxpayer in the office of the Secretary in accordance with rules or regulations prescribed by the Secretary.” It does not say the assessment is made “by the taxpayer in accordance with forms, rules or regulations prescribed by the Secretary.” If, somehow, the proper IRS official does not sign the proper document, then there is no assessment for the IRS to collect, regardless of what the taxpayer submitted on his or her return. Taxpayers have actually won in court when they submitted returns that were not then properly assessed, sometimes to the tune of multiple millions of dollars in lost taxes. If our system were, truly, a system of self-assessment, those cases would never happen.

Nor is our system is one of self-assessment as a factual matter. It is more accurately described as a system of coerced self-reporting, as anyone who received an erroneous W-2 or 1099 will attest. It is true that the IRS accepts a high percentage of taxpayer returns as filed and records the tax liabilities reported on those returns. This might lead one to believe the system is one of self-assessment de facto if not de jure. To understand why that belief is wrong one must first understand that assessments, are not ministerial actions but are discretionary actions, as seen in the case law: they reflect a judgment of what taxes are owed. In fact, the IRS does not have to make an assessment; it could choose to instead file suit in federal court. Go read §6501(a) of the Tax Code, the statute of limitations on assessment. Did you ever stop to ask why it reads that the IRS must either assess or bring proceedings in court without assessment within three years after the return is filed? It is because an assessment is an administrative judgment of taxes owed, which triggers administrative collection powers; it is an alternative to the IRS filing a complaint in court and obtaining a court judgment.

So while taxpayers file returns, they do not assess their own taxes. Nor does the IRS blindly accept returns as filed and assess taxes based on whatever the taxpayer puts on a return. But more on that tomorrow, when we get to Myth #5.

 

Taking Issue With the Ninth Circuit and Lavar Taylor’s View of A Willful Attempt to Evade or Defeat Tax

Today’s post is from Professor Bryan Camp, the George H. Mahon Professor of Law at the Texas Tech University School of Law. Bryan is a prolific scholar whose work on tax procedure and administration is thoughtful and provocative. In this post, Bryan responds to Lavar Taylor’s posts from two weeks ago on the Ninth Circuit Hawkins case. We are thrilled to welcome Bryan as a Procedurally Taxing guest blogger. Les

Bankruptcy Code (“BC”) §523(a)(1)(C) prevents the discharge of a tax when a debtor “willfully attempted in any manner to evade or defeat such tax.” The recent 9th Circuit decision in Hawkins v. Franchise Tax Board, — F.3d – , 2014 WL 4494845 (9th Cir. No. 11-16276, Sept. 15, 2014) interpreted “willfully” to require a specific intent on the part of the debtor to evade taxes, which must be evidenced by some affirmative act of evasion committed by the debtor. All the other circuit courts to consider this issue have interpreted “willfully” to require only that the debtor make a voluntary and conscious choice to use money for non-tax purposes at a time when the debtor has the means to pay on the tax liability now sought to be discharged. In re Fegeley, 118 F.3d 979 (3d Cir. 1997); Matter of Bruner, 55 F.3d 195 (5th Cir. 1995); In re Toti, 24 F.3d 806 (6th Cir. 1994); Matter of Birkenstock, 87 F.3d 947 (7th Cir. 1996).

In particular, if a debtor lavishly spends money on luxuries far beyond the debtor’s means, racking up debts to other creditors at a time the debtor knows about a tax debt, that is sufficient to be a willful attempt to evade or defeat such tax and render the tax debt non-dischargeable.

That is what apparently happened in Hawkins: in the judgment of the bankruptcy court, affirmed by the district court, the Mr. Hawkins’ spending was so over the top that it amounted to a willful attempt to evade or defeat his tax debts. The 9th Circuit reversed because no one had connected the lavish spending to a specific intent in Mr. Hawkins’ mind and willfulness required a specific intent to evade.

The 9th Cir. decision bucks the majority view. It has sparked two laudatory posts from A. Lavar Taylor (Lavar), who authored an amicus brief in the case. Lavar believes the 9th Cir.’s decision was: (1) the right legal interpretation of 523(a)(1)(C); and (2) practically preferable to the majority interpretation because makes for a clearer and more uniform application of the law. Since I respectfully disagree with Lavar on both points, Keith, Les and Steve have kindly lent me their blogspace to give my alternative analysis.

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1. The 9th Circuit Misinterpreted 523(a)(1)(C).

Key to both the 9th Circuit’s and Lavar’s legal analysis is an argument built on language used over in the Internal Revenue Code (“IRC”). IRC §7201 makes it a felony to “willfully attempt[ ] in any manner to evade or defeat any tax.” This language is almost identical to the language used in §523(a)(1)(C). In the felony tax statute, the term “willfully” does require the Government to prove that the law imposed a duty on the defendant, that the defendant knew of this duty, and that he voluntarily and intentionally violated that duty. See e.g. United States v. Bishop, 291 F.3d 1100, 1106 (9th Cir.2002). The 9th Cir. thought that the similar language in the Bankruptcy Code should be construed similarly.

The 9th Cir. found nothing in the legislative history of the Bankruptcy Provision to negate its decision to read the Bankruptcy Code provision in pari materia with the IRC. And it explicitly relied on the Supreme Court’s decision in Spies v. United States, 317 U.S. 492 (1943). There, the government had asked the Court to interpret the term “willfully” in the felony tax statute quoted above in the same way that the term “willfully” had been interpreted in a nearby misdemeanor tax statute. The 9th Circuit explained the importance of Spies to its way of thinking like this:

the Court considered the difference between the misdemeanor of willfully failing to pay a tax or file a timely return (§ 7203) with the felony of willfully attempting to evade or defeat a tax or its payment (present § 7201). The Supreme Court rejected the government’s contention, which is similar to the one it takes in this case, that a willful failure to file a return, coupled with a willful failure to pay the tax, constituted a willful attempt to evade or defeat a tax in violation of § 7201. Rather, it interpreted the statute as requiring some willful commission in addition to willful omissions. It then provided some examples of qualifying acts, including keeping double books, making false bookeeping entries, destruction of records, concealment of assets, along with any kind of conduct, the likely effect of which would be to mislead or conceal. Applying the logic of Spies, which was construing language almost identical to the phrase at issue, simply spending beyond one’s income would not qualify as a “willful [ ] attempt[ ] in any manner to evade or defeat such tax. (Internal quotes, citations, omitted)

I think the 9th Circuit’s analysis is deficient. If one is going to look to the IRC and judicial glosses on it, the 9th Circuit looked in the wrong place and, therefore, came to the wrong interpretation.

The 9th Cir. looked at the meaning of the term “willfully” as interpreted for criminal tax statutes, not civil statutes. But BC §523 is a civil statute, not a penal statute. Nor is the greater purpose of the Bankruptcy Code penal. It has two well-known purposes that exist in tension. First, it exists “to provide a procedure by which certain insolvent debtors can reorder their affairs, make peace with their creditors, and enjoy a new opportunity in life, a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.” Grogan v. Garner, 498 U.S. 279, 286, (1991)(internal quotes omitted). We can call this the “fresh start” purpose. A second purpose is to help competing creditors get the most money they can in an efficient and orderly manner. See generally, Elizabeth Warren, Bankruptcy Policy, 54 U. Chi. L. Rev. 775 (1987). These twin aims of bankruptcy recognize the value of bankruptcy outcomes tracking non-bankruptcy outcomes but justify alteration of those outcomes by the fresh start concerns. Id. Section 523(a)(1) reflects these twin aims in the tax debt context. In particular bankruptcy courts must exercise judgment here on whether and under what circumstances the non-bankruptcy outcomes should be altered to give debtors that fresh start. Put another way, the bankruptcy judge’s job is to discern whether the debtor was honest but unfortunate or whether the debtor was trying to stiff the government. It’s the classic distinction between the unlucky and the unscrupulous, the schlemiel and the schmuck. Either way, the purpose of the Bankruptcy law is not to penalize: the debtor is either relieved of debt or required to still owe it. One might even say the purpose of bankruptcy is remedial, either in favor of the debtor’s fresh start, or in favor of allowing creditors to continue pursuing their non-bankruptcy remedies.

So if one is going to look to the Tax Code for guidance, it would seem to make more sense to look to the civil provisions of the Tax Code that use the concept of “willfully attempt to evade or defeat” rather than the criminal provisions. When one does so, one finds loads of precedent interpreting tax law concepts of “willfully” differently in the civil tax provisions than in criminal provisions, even where the civil and criminal provisions use the exact same language.

Perhaps the best example of this dual construction of the same word (“willfully”) is to compare and contrast IRC §6672 with §7203. Both provisions deal with the duty imposed on several groups of persons to collect, account for and pay over to the government various taxes imposed on other persons. The best known example of this duty is the duty imposed on employers with respect to their employee’s social security taxes and income taxes. See IRC §3102(a)(social security taxes); §3402(a)(1)(income taxes). These taxes are known as “trust fund” taxes because the money collected is deemed to be held in trust for the United States. IRC §7501(a); see United States v. Strebler, 313 F.2d 402, 404-05 (8th Cir. 1963). They are also called “third party” taxes because the duty is to collect someone else’s tax. Slodov v. United States, 436 U.S. 238, 249 (1978).

IRC §6672 imposes a civil penalty on any person who, under a duty to collect a trust fund tax, “willfully fails to collect such tax, or truthfully account for and pay over such tax.” The penalty amount is 100% of the amount not paid. So it is a pretty hefty consequence. Worse, and especially relevant here, Congress has made this 100% penalty nondischargeable in bankruptcy because it is a priority claim under BC 507(a)(8)(C) that is excepted from discharge by BC 523(a)(1)(A).

IRC §7202 is the criminal analog to §6672. It provides that any person who, under a duty to collect a trust fund tax, “willfully fails to collect or truthfully account for and pay over such tax shall, in addition to other penalties provided by law, be guilty of a felony.”

So here we have two IRC provisions, one civil and one criminal, that use exactly the same phrase to describe the prohibited conduct. Yet the courts have long interpreted the term “willfully” very differently for §6672 purposes than for §7202 purposes. As the 7th Circuit explained: “in criminal statutes, ‘willfulness’ generally requires bad purpose or the absence of any justifiable excuse . . . . In civil actions, however, these elements need not be present. Rather, willful conduct denotes intentional, knowing and voluntary acts.” Monday v. United States, 421 F.2d 1210, 1215 (7th Cir.), cert. denied, 400 U.S. 821 (1970).

For example, in Domanus v. United States, 961 F.2d 1323 (7th Cir. Ill.1992), Mr. Domanus was convicted of a civil violation of IRC § 6672 for willfully failing to withhold employee social security and income taxes, under a definition of “willfully” as “voluntary, conscious and intentional—as opposed to accidental—decisions not to remit funds properly withheld to the Government.” Id. at 1324. He argued that the government should be required to prove “willfully” according to its settled definition in the companion criminal provision, that is, an intentional violation of a known legal duty. The court held, however, that while Congress had evidenced an intent that the term “willfully” be interpreted strictly for criminal tax statutes, that strict definition was not required in applying civil tax statutes,” because the purpose of the civil remedies was to allow “the United States the ability to collect wayward trust fund taxes.” Id. at 1326.In effect, the different purposes attendant to the civil and criminal parts of the statute warranted different interpretations of the same term.

Nor is the different interpretation of “willfully” in civil and criminal provisions confined to the context of tax statutes. in Laffey v. Northwest Airlines, Inc. 567 F.2d 429 (D.C. Cir. 1976), the issue was whether the term “willful” in a civil provision of the Fair Labor Standards Act (29 U.S.C. §216(d)), had the same meaning as the same term used in a criminal provision, (§216(a)). The defendant had contended that the term “willful” meant the same thing in both provisions: bad purpose or evil intent. The court instead adopted a less strict definition of the term for its use in civil cases.

[Defendant] contends that “willful” in the suit-limitation provision takes on the interpretation given the same word in the criminal provision…. We do not agree that the criminal construction is to be imparted into the civil provision simply because both provisions are part of the same statute. The purposes of the two sections are entirely different; one punishes as criminal certain specified conduct while the other subserves a policy to which punishment in entirely foreign. Laffey, 567 F.2d at 461-462, n230.

Thus, far from being a game-winner, the Spies case—where the S.Ct. was comparing the language in two criminal tax statutes, is just a non-starter in analyzing the proper meaning of “willfully” in BC §523, a civil and remedial provision.

The 9th Circuit just got it wrong; the majority of courts who have decided that “willfully” means only an intentional act—as opposed to accidental—have the better interpretation.

2. The 9th Circuit’s Decision is Not Practically Preferable

Lavar also argues that even under the civil willfulness standard, Mr. Hawkins was not willful under the facts of the case. That very well may be. I do not quarrel with the facts of the case, only with the 9th Circuit’s interpretation of the legal meaning of the term “willfully.” I am not defending the bankruptcy court’s application of facts to the legal standard it used. I am just defending the legal standard: a tax should not be dischargeable if the debtor made a voluntary and conscious choice to use money for non-tax purposes at a time when the debtor has the means to pay on the tax liability now sought to be discharged.

Lavar takes his quarrel with the bankruptcy court’s application of facts a bit further. He argues that reading “willfully” to include behavior such as Mr. Hawkins will create great uncertainty over what expenditures by the debtor a court will find to be unnecessary and therefore satisfy the willfulness requirement for non-discharge. Lavar raises many good questions where there may be difficultly in discerning true need from lavish spending.

The short answer here that Lavar is surely correct that the civil standard for willfulness—the correct legal standard in my view and the view of all but one Circuit Courts of Appeal—leaves more room for more debtors to find their income tax liabilities non-dischargeable. Two thoughts, however, give me comfort that Lavar’s parade of hypotheticals is not so horrible.

First, discernment is what we pay bankruptcy judges to do. They are, after all, paid to “judge” and that means take into account all the facts and circumstances. So a complaint that a legal standard requires a judge to discern and label behavior does not trouble me inherently. The bankruptcy judges must explain their decisions and are subject to at least two levels of review. I presume, as we all presume, that our judges are capable people. Certainly the Supreme Court believes so, leaving to district court the responsibility to discern whether a transfer of property or cash in a business relationship is an excludable gift under IRC §102(a). Duberstein v. Commissioner   (mainsprings of …)

Second, the 9th Circuit’s decision to apply a criminal standard of willfulness to the civil bankruptcy statute does not eliminate the need for discernment. The criminal standard is no more “principled” (to use Lavar’s term) than the civil standard in that regard. If anything, it imposes a more difficult task on judges: to discern the internal mental state of the debtor. And it just shoves the discernment task further down the behavioral line so that fewer debtors will cross that line and fewer taxes will be non-dischargeable.

And that is the meat of the dispute here: do we want our bankruptcy scheme to favor the fresh start here or do we want it to favor preserving the non-bankruptcy relationship between debtors and their tax creditors?   Whatever good reasons there may be to favor the fresh start, the 9th Circuit’s opinion in Hawkins is just not the place to find them.