The Empire Strikes Back on Excessive Refundable Credit Claim Penalties

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We welcome back frequent guest blogger Carl Smith who is taking on extra guest blogging duties while the three of us are tied up with a book publishing deadline.  Today’s post looks at a newly released pronouncement on the Rand issue.  Even though the IRS has conceded the issue raised in Rand the issue is unlikely to go away for a very long time because the IRS has declined to go through its records to remove the improperly assessed penalties.  Taxpayers who do not realize they have the right to have this penalty abated, will be paying for it for the next 10 years, or longer, as collection action continues on an item where the IRS has conceded it made incorrect assessments.  Its actions on this issue make it hard to build up sympathy for the IRS when it asks for new and more convenient ways to make assessments since it has told taxpayers it will not pull down incorrect assessments such as the one in Rand case without specific action by an impacted taxpayer.  Keith

 

There have been a number of blogposts over the last two years on the case of Rand v. Commissioner, 1141 T.C. 376 (2013). In Rand, a majority of Tax Court judges held that, for purposes of section 6662’s accuracy-related penalty, the “underpayment” at section 6664(a) on which the penalty could be imposed did not include disallowed refundable tax credits — except to the extent that such credits reduced the tax down to zero, but not below zero.  This holding was in spite of the conceded fact that the language of section 6211 in defining a “deficiency” includes disallowed refundable credits, with no limitations on how those credits were used (i.e, whether or not they reduced tax below zero and generated refund checks).  We reported that the IRS did not appeal its loss in Rand and that, on July 31, 2014, in Chief Counsel Notice CC-2014-007, the IRS told its attorneys to concede the Rand issue in all pending Tax Court cases.

When Andy Roberson of McDermott Will (as lead counsel for the Rands) and I (as amicus) litigated Rand, we knew that, if we won, the IRS had an alternative 20% penalty that it could apply, at least, to disallowed refundable tax credits other than the earned income tax credit (EITC).  The penalty was at section 6676 and is intended for excessive claims for tax refund or credit.  The section 6676 penalty (at subsection (d)) provides that it does not apply to the extent that the excessive claim is subject to a penalty on the same disallowance under part II of subchapter A of chapter 68 (i.e., the sections 6662 and 6663 penalties for inaccuracy and fraud).  But, the IRS had largely ignored the section 6676 penalty (adopted by Congress in 2007).  I have still never seen it asserted.  And it seemed likely to us that the statute of limitations would have precluded the IRS from belatedly asserting the section 6676 penalty against the Rands as a partial alternative to the section 6662 penalty — the Rands having claimed the EITC, the additional child tax credit (ACTC), and the section 6428 recovery rebate credit on their timely original return.  Part of our assumptions was that section 6676 is contained within the assessable penalties of subchapter B of chapter 68, and section 6671 provides that “[t]he penalties provided by this subchapter shall be paid upon notice and demand . . . and shall be assessed and collected in the same manner as taxes”.  At least I know I assumed that the the IRS, under section 6501, would have only three years after the filing of the offending return to assess the section 6676 penalty, and that period had expired.  But, on February 18, 2015, Tax Notes Today published Program Manager Technical Assistance (PMTA) Memorandum 2014-015 at 2015 TNT 32-13.  That memorandum had been originally issued on August 6, 2014, contemporaneous with the Chief Counsel memorandum on Rand. In reading the PMTA, I find that the IRS has now taken new positions on the section 6676 penalty that will make the penalty easier to assert against taxpayers — some of which positions are surprising and some even possibly wrong.

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First, before discussing the PMTA, there are only a few more things you need to know about the 20% section 6676 penalty:  It applies not to the “underpayment” under section 6664(a), but to the “excessive amount” — which is defined simply as “the amount by which the amount of the claim for refund or credit for any taxable year exceeds the amount of such claim allowable under this title for such taxable year”.  The penalty cannot be imposed to the extent the excessive amount “has a reasonable basis”.  The statute excludes from the “reasonable basis” exception any disallowance attributable to a transaction described in section 6662(b)(6) because it lacks economic substance under section 7701(o) or does not meet the requirements of any similar rule of law.  Erroneous EITC claims are also excluded from the section 6676 penalty.  Presumably, Congress excepted the EITC from this penalty because the IRS already had a penalty at section 32(k) to impose on erroneous EITC claims that, depending on the gravity of the conduct, can prohibit a taxpayer from claiming the EITC for the next two or ten years.

The PMTA takes the position that “reasonable basis” has the same meaning in section 6676 as in section 6662 and the regulations thereunder.  Thus, this “reasonable basis” is simply an objective test.  This conclusion is likely correct.  Note that, after Rand, Nina Olson called in her 2014 Annual Report to Congress for a provision amending section 6676 to add an exception for “reasonable cause and good faith” — a more subjective test that can be found in section 6664(c)(1). See http://www.taxpayeradvocate.irs.gov/Media/Default/Documents/2014-Annual-Report/ERRONEOUS-REFUND-PENALTY-Amend-Section-6676-to-Permit-Reasonable-Cause-Relief.pdf.

Another ruling in the 2014 PMTA is what might be called an unexpected consequence of taxpayers winning the Rand case.  The regulations under section 6664(a) give a mathematical equation for the “underpayment” as W – (X + Y – Z), where W is the amount of income tax imposed, X is the amount shown as the tax on the taxpayer’s return, Y is the amount not so shown previously assessed (or collected without assessment), and Z is the amount of rebates made.  On May 30, 2012 (while Rand was under litigation), pursuant to pressure from low-income taxpayer advocates, in PMTA 2012-016 (reprinted at 2012 TNT 163-18), the IRS held that there was no “underpayment” when a refund was frozen because ‘[i]f the Service has not refunded or allowed a credit to the taxpayer for the erroneously or fraudulently claimed FTHBC or EIC, absent additional circumstances, the amount of such credit is added to Y because it is a sum collected without assessment.  For most taxpayers the net result will be that X and Y cancel each other out and consequently no ‘underpayment’ exists.”  This interpretation flew in the face of tens of thousands of notices of deficiency that had been issued seeking section 6662 penalties on frozen refunds.  So, the IRS went back and abated over $142 million of erroneous section 6662 penalties.  See Nina Olson’s discussion of this abatement and her dissatisfaction that the abatements did not go back far enough, since she thought another $40 million needed to be abated.

Rand now holds there is no “underpayment”, whether or not the refund was frozen, to the extent the refundable credit reduced taxes below zero.  That sounds great, but that means, according to the 2014 PMTA, that a section 6676 penalty can be imposed instead on the erroneous refundable credit amount not included in the “underpayment” (so long as it is not on the EITC and the taxpayer did not have a reasonable basis).  So, this different 20% penalty applies even where the refund was frozen.  This result actually seems what Congress intended, since the 6676 penalty was designed to hit returns or amended returns erroneously asking for a refund, regardless of whether the IRS paid the refund.  Such returns cause the IRS to expend resources dealing with them, even if the IRS never sends the money.  But, I suspect that low-income taxpayer advocates were not hoping to jump out of the frying pan of section 6662 into the fire of section 6676 when refunds were frozen.

A third issue discussed by the PMTA is how the section 6676 penalty is to be assessed.  Frankly, I read the Code as providing that the assessment is done like a section 6672 responsible person trust fund penalty — straight to assessment, without the deficiency procedures applying.  That seems to be what section 6671 provides.  But, the PMTA takes the position that only for underlying issues on which the section 6676 penalty applies where there is no jurisdiction in the Tax Court under the deficiency procedures, such as for excessive refund claims regarding employment taxes or the section 6707A reportable transaction penalty, the section 6676 penalty is done by straight assessment, without prior notice to taxpayers.  However, for section 6676 penalties on what would constitute a “deficiency” — and excessive refundable credit claims are clearly part of a deficiency under section 6211(b)(4)‘s special rules — the PMTA concludes that the section 6676 penalty should be asserted in a notice of deficiency.  The PMTA reasons that Tax Court cases have in the past held that a penalty which is computed as a function of a deficiency (which I would point out includes extra late-filing and late-payment penalties on the tax deficiency) are also treated under the deficiency procedures.  This reasoning is all mixed up.  The Tax Court applies the deficiency procedures to penalties like the late-filing and late-payment penalties of section 6651(a) that are imposed on the tax deficiency only because of special language in section 6665(b) that directs the Tax Court to do so.  There is no similar language in section 6671 directing deficiency procedures to apply to any penalties imposed in the following sections.

The PMTA notes that no court has ruled on the issue of whether the section 6676 penalty can ever be asserted in a notice of deficiency.  If, as I expect, the IRS starts including section 6676 penalties along with a disallowance of the underlying refundable credit in notices of deficiency, the Tax Court will likely dismiss the section 6676 penalty issue from the case for lack of jurisdiction.

A final point made by the PMTA is probably more correct, though the PMTA is vague and perhaps confused about the circumstances. We all learned a long time ago that amended returns do not start a new section 6501(a) (usually 3-year) statute of limitations running.  Rather, the Supreme Court held in Badaracco v. Commissioner, 464 U.S. 386 (1984), that it is the original return that commences the period under section 6501 in which to assess the tax and any penalty related thereto.  Badaracco actually dealt with a notice of deficiency merely seeking the fraud penalty more than three years after non-fraudulent amended returns were filed, though the original return was fraudulent.  It held that, since the original return was fraudulent, subsection (c)(3) provided for an unlimited period to assess taxes or penalties under section 6501.  I will not get into the confused facts of the example in the PMTA, but suffice it to say that the example deals with excessive claims on an amended return, and it notes that a section 6676 penalty can be imposed if none can any longer be imposed under section 6662 because the statute of limitations on assessment under section 6501 has expired.  The underlying assumption seems to be that an amended return containing an excessive claim for refund starts its own section 6501 (usually 3-years) period for the assessment of section 6676 penalties — one that obviously lasts longer than the normal section 6501 limitation period based on an original return.  I think this is right, though no court has so held.

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