FinCEN Moves To Include Convertible Virtual Currency On FBAR Form

We welcome back guest blogger James Creech, who describes an interesting development in the government’s efforts to track and tax virtual currency. Christine

Recently FinCEN has declared its intention to require convertible virtual currency (aka Bitcoin) to be reported on the FBAR. In order to begin the formal rulemaking process FinCEN published Notice 2020-2 stating that it intends to modify 31 C.F.R. 1010.350.

While not a formally a tax provision, filing delinquent FBAR’s and the IRS counterpart FATCA reporting were a main stay of the tax practice during the heyday of the offshore voluntary account disclosure program in the early to mid 2010s. As a result many practitioners would be well served by taking a second look at these proposed changes as more details become available.

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One issue that has always appeared to be a challenge for reporting virtual currency on both the FBAR and the 8938 is identifying where the asset is held. The blockchain that stores the data on virtual currency is hosted on a decentralized network stored upon tens of thousands of computers all across the globe. The keys (analogous to a password) that control the underlying virtual currency could be anywhere as well. While it was generally accepted that keys stored on a desktop in the United States were not held in a foreign account, there were a number of edge cases that became much tricker to administer. For example how do you report a UK based exchange that might hold custodial assets in a server in Iceland? Or if bitcoin is stored locally on a phone does it become a foreign account if the taxpayer travels (with their phone) to Portugal for 9 months?

In recent days FinCEN has been laying the groundwork for a potentially wide application of FBAR reporting requirements.  On December 23, 2020 FinCEN published a notice of proposed rule making that would require virtual currency transactions from self custodial or unhosted wallets (wallets that do not use a financial institution to store the virtual currency) to be reported on Currency Transaction Reports (CTR) if the amount transferred to or from a financial institution was more that $3,000. Part of this proposed rule making was to expand the definition of unhosted wallets as having a high risk of money laundering similar to bank accounts held in Iran or North Korea. And while this is even further removed from tax, administrative law devotees will be interested in the fact that FinCEN’s comment period for these proposed rules was only 14 days which included Christmas and New Years. (If you would like to read comments I submitted they can be found here and they expand on the risk of loss concerns contained below)

Based upon how aggressive FinCEN has been towards unhosted wallets and CTR reports it will be interesting to watch how they treat unhosted wallets for purposes of FBAR reporting, and if the IRS follows suit by amended the requirements for FATCA reporting via Form 8938. It may be that FinCEN takes a hard line and definitionally declares that all unhosted wallets are foreign assets and as such need to be reported on a taxpayer’s FBAR. Those that fail to do so may be subject to the same draconian penalties of $10,000 (non willful) or 50% of the highest account balance (willful) as those who fail to report a Swiss bank account.

A Word of Caution

While FinCEN does have legitimate reasons for potentially using the broadest definition of unhosted wallets possible, such a mandate may cause security and liability issues for tax practitioners. Beyond the technological aspects, the biggest difference between virtual currencies and traditional assets is that virtual currencies users have a 100% risk of loss if the private keys used to transfer the underlying virtual currency are lost or stolen. There is no way for a user to recover compromised keys after a hack or to undo a fraudulent transfer that is a result of a phishing attack. For those reasons, high value virtual currency users have relied on a combination of robust data security using an unhosted wallets, coupled with personal anonymity to protect their assets. The logic behind anonymity is simple. Unless a thief knows that a particular user has enough virtual currency to steal they are not a target. Sophisticated attacks are costly and security developers can quickly fix exploits once they become known or widely used. As such criminals chose there targets carefully.

Why this matters to tax practitioners is that the information required to file the FBAR would also provide a roadmap for bad actors to target and steal virtual currency from your clients. Hacking a law firms internal system would mean that bad actors would have access to a list of clients along with where they lived, their contact information, what their net worth was, and in the case of any voluntary disclosures a narrative of their dealings in virtual currency. Such information could be used to then target the end user directly.

This informational burden would exponentially raise the stakes on tax practitioner data security. Having virtual currency information stored on a firm’s computer would be the digital equivalent of having large amounts of cash stored in the office in perpetuity. It would also significantly raise the need for specialized malpractice insurance because filing a FBAR for someone with $50 million in virtual currency is completely unlike filing an FBAR with someone with $50 million in a Swiss bank account. If the bank account information gets hacked there are still several layers of institutional security that might prevent the attacker from successfully gaining access to the assets, not to mention bank deposit insurance that would compensate for lost funds. If the firm’s virtual currency FBAR client list was hacked, and the information was used to successfully target the client, then the firm would be responsible for an uncompensated $50 million loss.

Given how anonymity is synonymous with criminality in the eyes of law enforcement it is likely that FinCEN will seek to require significant information when drafting the virtual currency FBAR rules. If this does happen tax practitioners need to be aware that simply going back to the old FBAR playbook will not be sufficient, and that there are very real second order consequences for both legitimate virtual currency users and the professionals that they use to comply with the law.

Refund Offset versus Bankruptcy Exempt Property Claim

An important bankruptcy case was decided by the Fourth Circuit last spring that I missed, perhaps due to the pandemic – at least that’s my excuse because both Carl Smith and Nancy Ryan brought it to my attention at the time.  It came to my attention again last month thanks to Michelle Drumbl who directs the tax clinic at Washington and Lee and who will serve as interim dean there in the coming academic year.  This past semester Michelle was on sabbatical in Northern Ireland with her family but, as with most sabbaticals, she was writing during her time away from school producing at least one article on the cross over topic of bankruptcy and taxes.  Fortunately for me, she asked that I take a look at her draft of the article which caused me to finally pay attention to an interesting case that I ignored when Nancy and Carl brought it to my attention.  Michelle’s forthcoming article focuses on the case of Copley v. United States, 125 AFTR 2d 2020-XXXX (4th Cir. 2020) involving the issue of the interplay of IRC 6402, BC 362(b)(26), BC 522, BC 541 and BC 553

In prose the case concerns whether the IRS can offset a pre-petition income tax refund that the taxpayer claimed as exempt in his bankruptcy case against a pre-petition income tax debt.  The debtor argues that when the refund became exempt property it received a type of protection from the IRS offset not otherwise available, while the IRS argues the opposite.  The Fourth Circuit holds that exempting the refund does not protect it from offset.  I found this outcome totally unsurprising; however, the fact that the Fourth Circuit decision reversed the decisions of the two lower court judges in Richmond I happen to know as well as the absence of authority on this point did surprise me.  See the bankruptcy court’s opinion here and the district court’s opinion here.

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The Copleys filed a chapter 7 bankruptcy in May 29, 2014 listing the IRS as a priority creditor for over $13,000 claiming as exempt their 2013 tax refund of $3,208.  Virginia provides debtors a fairly stingy exempt property option, as do many former English colonies along the East Coast.  It allows the debtor to protect “money and debts due the householder not exceeding $5,000 in value.”  The Copleys used the exemption to elect to protect their 2013 refund and neither the IRS nor anyone else objected.  After making their exemption election, the Copleys filed their 2013 tax return on June 6, 2014, and the IRS offset the refund pursuant to IRC 6402 and BC 362(b)(26) which came into existence in the 2005 bankruptcy refund legislation and permits the IRS to exercise its offset rights despite the automatic stay prohibition against offset in BC 362(a)(7).  The automatic stay exception limits the IRS to offsetting pre-petition refunds against pre-petition debts of the same type of tax.  Here, the debt and the refund both satisfied the conditions of type and time.  No one objected to the offset based on a stay violation of BC 362(a)(7) rather the fight turns on the power of the exemption versus the power of the right to offset.

In appealing the case the IRS made two arguments.  First, it argued that the 2013 refund never became part of the Copleys’ bankruptcy estate.  Second, it argued that their right to exempt the property does not supersede the IRS right to offset.

The property of the estate argument raises the question of whether the Copleys even had the right to exempt the refund since they could only exempt property of the estate.  The IRS argued that:

A taxpayer can only have a property interest in a tax refund, not a tax overpayment, and the taxpayer can only have an interest in a refund if the overpayment exceeds preexisting tax liabilities.  Because the Copleys’ overpayment did not exceed their preexisting tax liabilities, the government asserts that their interest in the refund was valueless and, therefore, did not become part of the bankruptcy estate. (emphasis in original)

The Fourth Circuit did not buy this argument and that did not surprise me.  It pointed to the expansive nature of the concept of property of the estate, citing prior Fourth Circuit law as well as Supreme Court law.  The Court did note in footnote 3 that offset under IRC 6402 is discretionary which is inconsistent with the government’s position.  Two prior Fourth Circuit cases went to the Supreme Court that dealt with property of the estate.  I suspect this circuit may be more sensitive to this issue that almost any other circuit given that history.  Here, it cited to one of those prior cases that dealt explicitly with offset, Citizens Bank of Md. v. Strumpf, 516 U.S. 16 (1995) in pointing out that three things had to happen before offset could take place and none of those things had happened at the time of the bankruptcy petition.  In the IRS’s defense Strumpf and the other case, Patterson v. Shumate, 540 U.S. 753 (1992) pre-dated the 2005 amendment to IRC 362 excepting certain offsets from the automatic stay; however, that change did not remove the property from the estate under BC 541.  Rather than spending much of its time focusing on whether the Copleys’ refund became property of the bankruptcy estate, quickly concluding that it did, the Fourth Circuit moves on to describing the primary issue as one of the preservation of the right of offset despite the fact that the refund became part of the bankruptcy estate.

The IRS relied on the case of IRS v. Luongo, 259 F.3d 323 (5th Cir. 2001) where the debtor did not claim the refund as exempt until after the offset occurred.  The facts in Luongo were:

On May 19, 1998, Appellant Luongo filed for relief under Chapter 7 of the Bankruptcy Code. At the time of her filing she owed the IRS $3,800 in unpaid taxes from her 1993 tax year. On August 15, 1998, Appellant filed her 1997 income tax return showing an overpayment of $1,395.94. The bankruptcy court entered an order on September 10, 1998 discharging Appellant’s personal liability for her 1993 income tax deficiency. Subsequently, in November 1998, the IRS executed its claim to setoff and applied all of Appellant’s 1997 tax overpayment to her unpaid 1993 tax liability. 

Only after discharge and after offset did the debtors in Luongo seek to reopen their bankruptcy case and claim the refund as exempt.

Luongo involved a number of arguments not present in Copley but one of the argument the IRS won and on which it relied here was that the refund was not part of the estate.  The Fourth Circuit in Copley says that it does not dispute that conclusion of the Luongo decision.  I cannot reconcile the Copley decision and the reason for the Copley decision with that statement but, in the end, it does not matter whether the refund comes into the estate or not because of the decision of the Fourth Circuit on the second issue.

The second issue pits BC 553 preserving a creditor’s right to offset against BC 522 and the debtor’s right to exempt property.  The court acknowledges a conflict between BC 522 which protects exempt property against “any” prepetition debts and IRC 6402 which permits the IRS to offset “any overpayment” against preexisting liabilities.  It finds that BC 553 resolves the apparent conflict.

The critical language of BC 553 states “this title does not affect any right of a creditor to offset a mutual debt.”  That broad language, which caused me not to think that this case presented much of an issue, persuades the Fourth Circuit that the IRS can still make the offset even through the Copleys exempted the property.  It views acceptance of the Copleys’ argument as one which would violate the statutory directive of BC 553.  The court notes that BC 553 does not create the right of offset but only preserves an existing right.  Since IRC 6402 created a clear existing right, BC 553 steps in to preserve that right.

The court then addressed the Copleys’ arguments and knocked them down.  The one that most interested me was the argument that bankruptcy courts had the discretion to decide if BC 553 would apply.  The Fourth Circuit found that while bankruptcy courts could strike down a creditor’s attempt to offset, the basis for doing so derived from the questioning of the validity of the right of offset and not from some equitable discretionary ability to do so.

I think the Fourth Circuit got it right on both counts.  The refund comes into the estate but the IRS, or any other creditor with a valid right of offset, can exercise that right with the proper permission of the statute or the bankruptcy court.  Despite what I think, the lower courts here found the IRS could not offset.  This issue does not have much case law even though the bankruptcy code is well into middle age.  Perhaps, other debtors in other circuits will make this argument to see where it leads.

Making All Your Arguments in Collection Due Process Cases. Designated Orders, August 10 – 14, 2020 (Part Three)

The first two installments of this trilogy covered arguments that you are likely to raise in the hearing itself (the underlying liability), then moved to issues you might not be aware of until after the notice of determination is issued (procedural defects in assessment, or at least defects in the Appeals Officer verifying that the “applicable law or administrative procedures have been met.” IRC § 6330(c)(1). We end with an issue that is really only relevant after the hearing and in litigation: the record the Court will be able to review.

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Issue Three: The Administrative Record is Incomplete (Mitich v. C.I.R., Dkt. # 4489-19W (here))

Full disclosure: this order is not a CDP case (it’s a whistleblower case). But the admin record is critical for CDP cases. (And whistleblower cases. And innocent spouse cases.) So questions on the completeness of the administrative record are worth focusing on.

In cases where the reviewing court is confined to the administrative record, the agency is the party that submits that record. But that doesn’t mean the agency gets to dictate everything that is or should be in it. Still, the agency does have a fair amount of control over that record. And perhaps (though perhaps not -more on that later) the agency has even more control over what constitutes the administrative record in the first place when they promulgate regulations specifically defining the contents of administrative record.

It just so happens that whistleblower cases (like CDP cases) have a regulation on point for what comprises the administrative record. For whistleblower cases, the regulation is at Treas. Reg. § 301.7623-3(e) which provides in relevant part that the administrative record is comprised of “all information contained in the administrative claim file that is relevant to the award determination and not protected by one or more common law or statutory privileges.” In turn, the “administrative claim file” includes pretty much everything the Whistleblower Office reviews, as well as a final, catch-all category of all “other information considered by the official making the award determination.”

In the Mitich order, the whistleblower-petitioner thinks the tax return of the person they “blew the whistle” on should be in the administrative record. The IRS thinks that the return is not part of the administrative record, because the return was “not considered” in denying the whistleblower’s request. That may appear to be something of a head-scratcher, because in this instance the IRS clearly looked at the return (and the whistleblower’s information pertaining to it) before deciding not to pursue the tip. Indeed, the initial notes recommending denying pursuing the tip state “Rejecting claim as speculative after reviewing the taxpayers returns.” [emphasis added.]

There is nuance to the IRS’s position, however. The IRS argues that the official making the award determination didn’t rely on the return but rather relied on the initial employee (the “classifier”). Yes, the classifier relied on the return, but the classifier isn’t the official that made the determination, and in this case isn’t even a member of the IRS Whistleblower Office.

Judge Halpern isn’t entirely sold on that rationale, which leads to this order: that the parties provide a legal memo on why the return is or is not a part of the administrative record. This isn’t the first time the Tax Court has grappled with these sorts of issues. I was reminded of a previous order I covered in Whistleblower 6388-17W v. C.I.R. There, Judge Guy assigned extra homework to the parties (again, legal memos) on the tensions between IRC § 6103 and the parties’ (specifically, the whistleblowers) need to see the administrative file. Obviously, the IRS does not want to disclose any protected, confidential information, which may also provide some reason for them pushing so hard on why the tax return is not part of the administrative record here.

In any event, I somewhat doubt that whether the return is part of the record will have any bearing on Ms. Mitich getting any money. If the IRS never acted on her tip, and no proceeds were ever recovered, I am at a loss for how the tax returns help her. Yet looking at the order more broadly one can draw some other important lessons relevant beyond just the whistleblower context.

And this is where I return to the question, teased earlier: how much (legal) control does an agency have to restrict the administrative record? Because judicial review of whistleblower cases is limited by the “record rule,” exactly what the administrative record is and contains carries great importance. Two issues come to mind on that.

First, there is the issue of what should be in the record when both parties agree on the types of information that comprise the record rule but disagree on the contents. When problems arise under this category, the dispute is usually about the “completeness” of the record, and not the sorts of things that properly should be in it. For example, if both parties agree that all communications between the taxpayer and Appeals should be part of the record but a fax that the taxpayer sent to Appeals is not included, that would be an argument about completeness. This can be more fraught than it would otherwise appear.

One reason for discord is that the agency is generally the custodian of the administrative record. Taxpayers should be vigilant and keep their own “mirror” file and be ready to challenge the IRS’s version. And the Tax Court will likely entertain these challenges: in whistleblower cases, the Tax Court has held that “the Commissioner cannot unilaterally decide what constitutes an administrative record.” (T.C. 145 No. 8 (2015)) Problem (basically) solved.

But there is a second issue that I think is worth exploring: when the parties dispute the scope of the administrative record. Specifically, my concern is whether an agency can shield information from court review through promulgation of regulations narrowly defining the administrative record. Because I am more familiar with CDP than whistleblower cases, I will use CDP as the example.

The applicable regulation (Treas. Reg. § 301.6330-1(f)(2)(A-F4)), defines the administrative record in CDP cases pretty broadly, so arguments about its scope would likely be rare. Further, even where the “record rule” is in effect, it doesn’t render the administrative record unassailable: a petitioner can supplement the record where something needs to be explained. This, I believe, is most common with “call notes” from Appeals. Whatever notes Appeals takes during a call are part of the administrative record. Notes from the petitioner… not so much (at least not under the regulation). As a matter of course, my tax clinic always sends a fax to Appeals memorializing the conversation after a call so that it becomes “written communication […] submitted in connection with the CDP hearing.”

To be sure, I don’t have serious problems with the definition of the administrative record as provided by the regulation. But it isn’t impossible for me to imagine things I’d like to have as part of the administrative record which, by a strict reading of the regulation, might not be. One that comes to mind are communications made with Appeals after the Notice of Determination. On this point you may say, “well those conversations are plainly irrelevant since the Court is only looking at the Notice of Determination. Also, didn’t you write something about the Chenery doctrine before?”

I have. Also, it is entirely plausible to read the regulation such that those conversations would be part of the administrative file. My cause for concern is that when you’re dealing with a genuine abuse of discretion from IRS Appeals, you are often dealing with a constellation of questionable behaviors that does not end with the Notice of Determination. When IRS Appeals is being unreasonable I want every incidence of their unreasonable behavior to be in the administrative record. “Abuse of discretion” is a mushy and extremely difficult standard for the Tax Court (or practitioners) to work with. I would argue that demonstrating a pattern of IRS Appeals behavior, even if some if it occurs after the Notice of Determination is written, is relevant to that determination. I also think that regulations limiting court review, absent pretty explicit Congressional language supporting it, raises separation of powers concerns and arguably could be subject to being stricken down (see Carl Smith’s post on a related matter, here.)

Perhaps I am making a big deal of nothing in the CDP context, given the expansive language of the regulation. But what about in Innocent Spouse cases?

Recall that the Taxpayer First Act changed the scope of review in Innocent Spouse cases to “the administrative record established at the time of the [IRS] determination.” (IRC § 6015(e)(7)(A)) What does that administrative record entail?

Bad news for those who look to the regulations: they haven’t been updated since 2002. At numerous points, the regulations do not apply present law and are essentially obsolete. The regulation specifically dealing with Tax Court review (Treas. Reg. § 1.6015-7) provides one such example, taking the position that collection activity need not be suspended while requests are pending for equitable relief under IRC § 6015(f). This is not the case under the law as it currently stands (see IRC § 6015(e)(1)(B)(i)).

But apart from getting the law wrong, the regulation is also completely silent on the issue of what comprises the administrative record. Perhaps after the IRS crawls out from the heap of CARES Act and other guidance projects it has been tasked with, updates to that regulation may also be in order (it isn’t presently on the IRS priority guidance plan). But what is the Tax Court to do until then? What should be in the administrative record?

The Supreme Court has provided a little guidance on that topic. Judge Halpern cites to Citizens to Protect Overton Park v. Volpe, 401 U.S. 402, 420 (1971) for the proposition that “the record amassed by the agency consists of ‘the full administrative record’ before the agency.” Judge Halpern emphasizes the word “full” and notes that lower courts have interpreted that “fullness” to entail “all documents and materials that the agency directly or indirectly considered.” That seems pretty expansive. But I suppose we’ll have to wait and see… the issue is likely to come up sooner than later now that petitions being filed are subject to this record rule (see Christine’s post here).

Making All Your Arguments in Collection Due Process Cases. Designated Orders, August 10 – 14, 2020 (Part Two)

Welcome back to second of this three-part installment of “Making All Your Arguments in Collection Due Process Cases.” In Part One, we looked at a threshold question of when you are entitled to even raise certain arguments to begin with. The statute (IRC § 6330) precludes taxpayers from getting “two bites at the apple” in certain circumstances. These include arguing the underlying tax if you received a Notice of Deficiency or otherwise had an opportunity to argue the tax (IRC § 6330(c)(2)(B)). Note that while you do not have the right argue the underlying liability in those circumstances, you still can raise the issue and hope that the IRS Appeals officer decides to address it. See Treas. Reg. § 301.6330-1(e)(3)(A-E11). But it is in the “sole-discretion” of IRS Appeals whether to consider the issue in that case, and the decision (so the Treasury says) is not reviewable by the Tax Court.

Today, instead of relying on the goodness of the IRS Appeals Officer’s heart, we’ll dive into issues that the taxpayer almost always has the right to raise.

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Issue Two: The IRS Screwed Up (Procedurally) In Assessing the Tax (Mirken v. C.I.R., Dkt. # 18972-17L (here))

In a Collection Due Process hearing, if you focus on issues in the tax process the Tax Court will usually hear them out (go figure). If it was even remotely catchy, I’d suggest the following mnemonic device: In CDP, Subtitle F Gets You A’s and Subtitle A Gets You F’s. Feel free to never, ever think of that phrase again.

The Mirken order highlights the importance of CDP as a way to check the processes in assessment and collection. It also is worth giving Judge Copeland kudos for ensuring that justice is done where the pro se taxpayers may not have used the precise tax jargon a practitioner would.

As noted before, if you don’t raise issues in your petition you run the risk of conceding them. Sometimes you have a way out by arguing that the issues were tried by consent under Rule 41(b), but you don’t want to have to rely on this. You also need to allege facts supporting your assignments of error if you are the party with the burden of proof on them. On the rare occasion that you (petitioner) don’t have the burden of proof, you only need to raise the issue.

In CDP, one area where the IRS has the burden of proof is in verifying that all applicable law or administrative procedures have been met (IRC § 6330(c)(1)). Note again that you still have to raise that issue in your petition in the first place. Here, the unrepresented taxpayers did not raise this issue in their petition, but arguably did in their objection to the IRS’s summary judgment motion. Judge Copeland finds this to be sufficient to amend the pleadings under Rule 41(a), and then takes a look at the IRS’s records on the issue.

As is so often the case, the IRS records do not inspire confidence. A testament (again) to putting IRS records at issue at.

There are three assessments leading to liabilities here: (1) taxes assessed on the original return, (2) assessable penalties relating to the original return, and (3) taxes assessed through the deficiency procedures -in this case through the IRS Automated Under Reporter (AUR) program. In the Notice of Determination, the IRS Settlement Officer stated that she had “verified through transcript analysis that the assessment was properly made per [section] 6201 for each tax[.]”

This is something of a twist on the usual boilerplate I receive in my Notice of Determinations, which are extraordinarily unhelpful and usually just say, “I have verified that all procedures were met.” But even this twist (referring to transcript analysis and an actual code section!) won’t save the IRS. Being slightly more specific isn’t enough for the Tax Court to simply “trust” the determination.

For one, Judge Copeland notes that the taxes assessed under the deficiency procedures would not be assessed under IRC § 6201, but rather the deficiency proceedings (see IRC § 6201(e)). The most important component of deficiency proceedings is the Notice of Deficiency (again, go figure). With regards to the Notice of Deficiency, validity depends on the taxpayer actually receiving the notice with time to petition the court or the notice being properly mailed to the taxpayer’s “last known address” even absent actual receipt. See IRC § 6212(b).

There does not appear to be a record of the IRS Settlement Officer looking up if or where the Notice of Deficiency was mailed. In fact, as Judge Copeland notes, it doesn’t appear that the Settlement Officer knows what the taxpayers “last known address” would even be in determining the validity of a Notice of Deficiency. Should we just trust that the IRS did it right?

No, we should not. Especially not on a summary judgment motion from the IRS. And especially not when, as in this case, the Settlement Officer already sent a letter to the petitioners at the wrong address for this hearing.

Accordingly, Judge Copeland has no problem finding there to be a “genuine issue of material fact” that precludes summary judgment. And that is surely the correct outcome.

But before ending the lessons of Mirken I want to bring practitioners back to a threshold problem, and something I began this post on: raising issues in your petition. Frequently, in my experience, at a CDP hearing you are really only discussing the appropriateness of collection alternatives. A best practice would be to raise the procedural issues of assessment in the hearing, but when that doesn’t happen is it still acceptable to assign error to it in a petition? Can you do that under Tax Court Rule 33 when you don’t actually have a concrete reason (just general history and skepticism) to question that the IRS properly followed procedures?

I have two thoughts on that. My first thought is to amend the petition after getting the admin file. Hopefully that will happen soon enough that you can amend as is a matter of right, but often I doubt that will be the case. Fortunately, even if it takes a while to receive the administrative file my bet is that the Tax Court would freely allow an amended pleading if you are only able to learn of the problem later (I also doubt most IRS attorneys would object in those circumstances).

My second thought is that your standard practice should always be to request the administrative file as it exists in advance of the hearing. It is always a good idea to have as full a picture as possible on what information the IRS is working off. But beyond that, because of the Taxpayer First Act, you have a statutory right to the admin file in conferences with Appeals (see IRC § 7803(e)(7)(A)).

The most recent letters from Appeals I have received setting CDP hearings have specifically referenced the right of the taxpayer to request the file. It is always wrong (and not even an “abuse of discretion”) for the IRS not to follow a statute, and failure to send information you are legally entitled to certainly could be part of a Tax Court CDP petition. This isn’t an attempt to “set a trap” for IRS Appeals, but information that would be critically important for us to raise all potential issues at the CDP hearing. I know that I’ve made such requests to IRS Appeals and am still waiting…

DAWSON Updates

As we discussed here, the Tax Court rolled out its new case management system on December 28, 2020.  The rollout is the beginning of a process and not the end.  Today, the Court announced the first of what will probably be several announcements as new features come online.  This announcement provides information about the release of orders to the public.  Tax Court orders have long been a under observed aspect of the decision making of the Court.  Starting almost 10 years ago, the Court made these orders public and searchable.  The search feature is important for those wanting to track a specific issue or follow orders of a specific judge.  While orders do not create precedent, we found them sufficiently important to start the designated order feature here a few years back.  We look forward to the ability to track orders going forward in the same easy to search and free to all aspect of the Court’s online presence that greatly outperforms PACER.

A Brief Look At Section 7805(b)

We welcome back Monte Jackel, Of Counsel at Leo Berwick, who returns to discuss regulations that are made public but that are not published in the federal register prior to the end of a presidential administration. Les

Section 7805 was amended as part of the second Taxpayer Bill of Rights in 1996, P.L. 104-68, JCS-12-96, p. 44. Subsection (b), headed “Retroactivity of regulations”, describes the circumstances where retroactivity, that is where a “taxable period”, an undefined term, cannot be subject to a regulation filed or issued before certain dates, is permitted. Section 7805(b)(1)(A) references the date the regulation is filed with the Federal Register. The date of filing is a clearly known term given that the Office of the Federal Register uses that term as the date the document is available for public inspection before it is published there. Section 7805(b)(1)(B) also uses the filing date with the Federal Register to set the retroactivity that is permitted. However, section 7805(b)(1)(C) uses the term “issued” to the public when referencing the permitted retroactivity. That term is not defined although 5 USC 552(a)(1) (the APA) requires federal agencies to publish their regulations in the Federal Register. The term “issued” is not used there. Section 7805(b)(2), relating to promptly issued regulations, references the term “filed or issued” but defines neither. The legislative history does not add anything to this either. However, it is probably safe to assume that “issued” means “published”. 

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There has been some commentary recently about the upcoming change in administrations and what happens to regulations that are made available to the public before they are filed with the Federal Register but are not published there by the time a new incoming administration orders that all regulations not yet published (and maybe even those that are) be returned to the issuing agency. Attached at the end of this post is the text of a letter to the editor that I recently published in Tax Notes describing some of these issues. 

The practice of the IRS and Treasury releasing to the public a copy of a regulation with a disclaimer at the top of the first page saying that only the copy published in the Federal Register is the legal copy, should be discouraged. I can find no provision in either the Internal Revenue Code or the APA that authorizes this practice or gives any legal significance to it. And while this is not the first time in our history that presidential orders of a new administration put a “freeze” on the publication of regulations to evaluate them first, this practice only adds to the natural confusion created when a new administration takes power. The situation is exasperated when the text of the regulations are made available to the public but those regulations do not apply to any taxable period beginning before the regulations are published. What positions do taxpayers take in the interim. 

I think there should be a new federal statute that prohibits the issuance of regulations within 60 to 90 days before a new administration comes on board absent “extreme need” or other such standard, which is subject to review later. Alternatively, a new statute could describe the legal impact of these regulatory freezes. I much prefer the former. What do others think?

Text of Letter to the Editor, “Potential Danger of Making Public Pre-Release Versions of Regulations”
170 Tax Notes Federal 299, Jan. 11, 2021

To the Editor:

The Office of Information and Regulatory Affairs website says that the final section 163(j) regulations were released from OIRA on December 30, 2020. These regulations were, based on past IRS practice, posted on IRS.gov on January 5, 2021. Under the Congressional Review Act, the final regulations state that they will be effective on the date filed with the Federal Register. That date was either yesterday or today or will be shortly thereafter. But those regulations may not make it to be published in the Federal Register by January 20. That day, or the next day or so by the latest, a presidential executive order will be issued by the new administration ordering the Federal Register to return regulations not yet published there.
Emily L. Foster addressed the issue in her story last week [in Tax Notes] titled “Final Interest Regs Provide Clarifications for Taxpayers” but the story is a bit misleading when it discusses what happens if the regulations are pulled back by a new administration before they’re published in the Federal Register. It’s true that the regulations are effective on the date filed with the Federal Register under the CRA (assuming that the explanation given for the expedited effective date by the IRS stands up to challenge if it comes to it). That date was either January 5 or 6, or will be shortly thereafter.

But that only means that the regulations are legal documents upon filing with the Federal Register. However, the applicability date of the regulations is for tax years beginning on or after 60 days from the date of publication in the Federal Register. If the regulations are never published or publication is delayed for months, the regulations will not be mandatorily applicable to taxpayers and neither will the proposed regulations.

However, the final regulations state that taxpayers can elect to apply the final regulations to periods before they are applicable. Also, the final regulation preamble (but not the text of the regulation) says that prior to the applicability date, taxpayers can apply the proposed regulations instead. In addition, the final regulation preamble (but not the text of the regulation) states that if there is a rule from the proposed regulations that is not in the final regulations, taxpayers can nevertheless apply the proposed regulation rule until final regulations are published at a later date that deal with the omitted items. It is unclear what happens if the final regulations are never published in the Federal Register. In other words, can taxpayers rely on the proposed omitted items forever like they have for the proposed section 465 regulations (since the late 1970s)?

Eric Yauch wrote about the omitted items and other partnership rules in the final regulations in a story titled “Trading Partnership Approach Remains in Final Interest Regs”. The omitted rules from the proposed regulations were, principally, the creation of inside tax basis “out of thin air” upon a complete redemption of a partner and the application of section 734(b), and all the tiered partnership rules.
The latter rules were incoherent and difficult to follow and apply, even for partnership experts. But the final regulation preamble (but not the regulation text) says if a rule is omitted from the final regulations that was in the proposed regulations, a taxpayer can apply the proposed rules anyway.

That action could end up with the omitted rules being like the proposed section 465 regulations, which, as noted, have been proposed and not finalized since the late 1970s. This “can rely on the omitted rules” rule will literally be the case even if the final regulations are never published in the Federal Register or are published months from now. In the interim period before the omitted rules are addressed and finalized in one form or another, taxpayers are not obligated to apply the missing omitted rules from the proposed regulations, but they will have to apply a reasonable approach based on the statute and its legislative history.

Since the IRS does not explain why the omitted rules were not finalized, what other approach would be considered reasonable? Would a pure aggregate approach to tiered partnerships suffice? Can there be a situation when the “create basis out of thin air rule” applies without relying on how the proposed regulations handle that rule? How long will it be until these issues are resolved, if ever? The final regulation preamble states only that the partnership rules continue to be studied. Although that explanation sounds good, it’s probably truer to say that the omitted rules had technical and other issues and that the IRS could not figure out what changes should be made. They then ran out of time because the IRS powers that be wanted the final regulations pushed out the door before the new administration comes into power.

Is this course of behavior by the current IRS and Treasury advisable? The other regulations now pending at OIRA may also get posted to IRS.gov by January 20, but it is unlikely that those regulations will make it out as published in the Federal Register by that date. The section 1061 carried interest regulations come to mind. [Those regulations ended up being released to the public after this letter was submitted to Tax Notes]. That means that all those pre-publication regulations will most likely not be mandatorily applicable to taxpayers for months, if ever. Taxpayers can elect to apply those unpublished rules in the interim, but they don’t have to. Why do this?

In other words, if the OIRA-reviewed regulations have already been returned to the IRS, they may end up being a set of pre-publication regulations posted on IRS.gov which has, as a matter of law, absolutely no legal effect unless taxpayers elect that they apply. But what if they don’t so elect?

Such is the case with the section 163(j) final regulations. And it will be a race for other federal agencies to get their regulations filed and then published in the Federal Register by no later than the close of business on January 19, the day before inauguration day. If not, the same mess as with section 163(j) applies.

If pre-publication regulations that have been publicly released don’t make the January 19 Federal Register publication date, there will, as noted, be an executive order by the new administration shortly thereafter sending all unfiled and/or unpublished regulations back to the agency issuing them. At this point, it will likely be months before activity occurs on those regulations.

In the interim, how many taxpayers will gamble on the “new rules” that would apply to them once the regulations are resubmitted to the Federal Register by the new administration, and how many taxpayers will just apply the proposed regulations? Is it even safe to assume that the statements made by the current administration in the final section 163(j) regulations (that taxpayers can rely on those rules today) will not be changed by the new administration?
That latter action would be the height of unfairness but what stops a new administration from doing so? At that point, the Administrative Procedure Act would come into play in terms of how to render uneffective those regulations deemed effective by the good cause exception under the CRA? Would it be revocation and reissuance, or would it just be revocation under the CRA?
Is this good or bad tax policy for the current administration? To me, the answer is that it is resoundingly bad. What do others think?

Making All Your Arguments in Collection Due Process Cases. Designated Orders, August 10 – 14, 2020 (Part One)

My tax clinic has had a run of Collection Due Process (CDP) hearings lately -four in two weeks- after months of basically no action. I’ve found that historically my workload increases significantly this time of year, where cases that were long dormant suddenly spring to life with tight deadlines just before the holiday season.

Most of these “hearings” end up being a 2-minute phone call confirming that the Appeals officer received our Offer in Compromise and will wait for the Offer unit to make their preliminary determination before checking in again. Because most of my Offer cases are clear winners, the next step is usually just insisting on a Determination Letter (I am wary of waiving my rights to Court review for reasons detailed here) from Appeals months later when the Offer is accepted.

But there are times when my Clinic and Appeals doesn’t see eye-to-eye in the hearing, and we file a tax court petition (in addition to our four hearings, we’ve also filed two petitions under CDP jurisdiction in the last month). I’ve found that drafting these petitions is a bit more difficult for my students than the traditional deficiency petitions are, mainly because the assignments of error are not as straightforward as when you are reading off a Notice of Deficiency. But if you don’t raise an issue, you potentially concede it (Tax Court Rule 331(b)(4)) so we want to cover all of our bases -especially when we think the conduct of Appeals was objectionable in myriad ways, and want to highlight all of the relevant facts showing that.

Often my students want to argue two things: (1) the IRS abused their discretion by [whatever specific thing they failed to consider] rejecting the Offer, and (2) Something else. But they’re not really sure what that something else is, so it often starts out as some version of “and Appeals was mean when they did it.” Three of the designated orders for the week of August 10, 2020 provide something of a checklist for what arguments you may want to raise in CDP litigation -a way to supplement or supplant the “something else” assignment of error. (The remaining fourth order of the week is not substantive but can be found here.)

Let’s take a look at the three, and the issues they raise, in something close to a chronological order of when the issue would come about.

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Issue One: The IRS Should Have Let Me Argue the Underlying Tax! (Iaco v. C.I.R., Dkt. # 19694-18L (here))

Metaphorical barrels of metaphorical ink have been spilled on this blog about when taxpayers are entitled to argue the underlying tax in a CDP hearing under IRC § 6330(c)(2)(B). The thorny issue centers on what comprises a “prior opportunity” to contest the tax. Some of the blog’s coverage can be found here, here, and here.

In my humble opinion, the Tax Court has taken an overly broad view of what comprises a “prior opportunity” precluding taxpayers from raising the underlying tax. Thus, a taxpayer that wants to raise that argument (like Iaco in the above order) already has an uphill battle. For Iaco it is perhaps less of a hill and more of a wall.

The taxes at issue are excise (a tax on wagers under IRC § 4401(a)(2), which I’ll confess I was wholly ignorant of prior to now) which are not subject to deficiency procedures. Where a Notice of Deficiency is not required, under Lewis v. C.I.R., 128 T.C. 48 (2007), the inquiry is usually “did you already take your shot with IRS Appeals before the CDP hearing?” Here, Mr. Iaco did indeed take that shot, and now wants to take it again with a new Appeals officer in the CDP hearing.

(For those interested, the Iaco order could also provide a good lesson on the importance of record keeping. It appears Mr. Iaco ran an illegal gambling operation, busted in part because of a one-day wiretap. The IRS used the information from that one-day tap and extrapolated additional wagers based on it. Mr. Iaco said, “no way is that accurate!” but refused to provide any actual records of what the right amount of wagers was. In other words, Mr. Iaco failed to keep records like he is required to (see Treas. Reg. § 1.6001-1). This puts the ball firmly in the IRS’s court. And while they can’t just pick a random number, there is case law that allows the IRS to multiply the amount of wagers documented for one day by the likely period of wagering.)  

If your argument boils down to “I want to argue the tax with Appeals again because I don’t like what Appeals decided the first time,” you aren’t going to get very far. But there is perhaps a sliver of a kernel of an argument that you can still make: instead of arguing with the outcome of the first Appeals hearing, you argue with the process.

Mr. Iaco wants to argue that he never really had a prior opportunity, because the first Appeals conference was not a “fair and impartial hearing.” IRS Appeals is supposed to be independent and there is at least some statutory authority geared at ensuring that impartiality (see IRC § 7803(e)). Might there be a baseline standard of conduct from Appeals for the hearing to qualify as an “opportunity?” If so, how do we determine that baseline?

Judge Halpern has some thoughts on that question and looks to Supreme Court precedent to guide his analysis -specifically, Mathews v. Eldridge, 424 U.S. 319 (1976).

Mathews is one of the handful of name cases I recall from law school and it is all about “procedural” due process. If I were to dredge up my old flash cards, my bet is they would have something to the effect of “Issue: how much process is due?” The other side of the flash card would (hopefully) lay out this abridged three factor test: (1) what’s the private interest being affected, (2) what’s the risk of the current procedures erroneously depriving that interest, and (3) weigh those considerations against the government’s interest/costs were the procedures changed. Swirl those factors around and you will get an idea for the amount of process (for example, providing an evidentiary hearing) that is due before the deprivation of the private interest (in Mathews, the denial of social security disability payments).

Constitutional procedural due process does not require that the IRS provide a “Collection Due Process” hearing before depriving an individual of their property (i.e. levying) to pay back tax. Indeed, the IRS did not provide CDP hearings prior to 1998 and their collection methods certainly weren’t unconstitutional up to that point. So what value does Mathews have here, when a facial attack on the constitutionality of the IRS’s collection procedures would be sure to fail?

Remember, Mr. Iaco’s issue is mostly with the first Appeals hearing he received, where he argued against the IRS calculation of wagers and didn’t feel as if he were being heard. There is a specific line in Mathews which Judge Halpern quotes: “The fundamental requirement of due process is the opportunity to be heard at a meaningful time and in a meaningful manner.” Mathews at 333 [internal quotes omitted]. This gets at the issue of looking beyond procedures broadly to how they are applied individual specifically. Yes, these procedures exist and meet the requirements of constitutional due process, but were they properly administered? Mr. Iaco says Appeals was just a rubber-stamp for the initial tax determination. The question is, did Mr. Iaco have a meaningful opportunity to explain himself and be heard by the Appeals Officer?

The Tax Court finds Mr. Iaco did, so he is out of luck. Other taxpayers, however, may have better facts, which is why I think this order is worth considering in the constitutional dimension that Judge Halpern raises. As I’ve noted before, I think the Tax Court has narrowed taxpayers’ opportunity to argue the underlying tax in a CDP hearing beyond what the statutory language requires or Congress intended. The current state of the law is such that if you had a hearing with Appeals arguing the tax (even through audit reconsideration), you have now blown your chance to raise it in a CDP hearing and get Tax Court review. I think this creates a massive trap for the unwary, and perversely incentivizes waiting until CDP to argue your tax rather than dealing with it at an earlier stage. My hope is that circuit courts will take up the issue and reverse the Tax Court interpretation of the statute.

For now, an opportunity with Appeals essentially always equals a “prior opportunity” to dispute the tax under IRC § 6330(c)(2). The only (possible) way around it that I can see is to argue that the first opportunity with Appeals wasn’t an opportunity at all, because it wasn’t meaningful. At the very least, Judge Halpern appears to contemplate that as a precondition under Mathews. I imagine you’ll need a lot of facts for that heavy lift, showing any number of IRS Appeals abuses, to make that showing.

Until that happens, we have to look for a new argument in our CDP petition…

TIGTA Audit Flags Inconsistency in IRS Treatment of E-filed Returns

A recent report from TIGTA highlights the IRS’s inconsistent treatment of millions of e-filed returns that have errors.  IRS e-file processes consider an e-filed tax return as “filed” when the IRS accepts the return for processing, not when the IRS originally receives the return. The TIGTA report reveals that IRS does not have the  “the ability to use the date an e-filed return was initially received as the return filing date.” This is a problem because under the commonly used Beard test the IRS routinely rejects legally sufficient returns, triggering delinquency penalties and uncertainty as to the statute of limitations on assessment, a topic that Keith discussed in Rejecting Returns that Meet Beard. That post covered Fowler v Comm’r, which held that a rejected an e-filed return the return still triggered the 3-year limitation period on assessment. The TIGTA report suggests that there are systemic issues stemming from the IRS practice of rejecting e-filed returns, issues that will likely require a legislative fix or a significant change to internal IRS practices.

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Unlike submitting a return by snail email, when e-filing a return it generates the possibility of the IRS rejecting a return (so called validation problems). Even if an e-filed return is validated, as with paper returns sent via regular mail, the IRS may notice errors that trigger Error Resolution System (ERS) scrutiny. TIGTA notes that there were about 26 million ERS issues on 2019 individual returns, with over 24 million of those errors attributable to “when the tax liability, balance due amount or refund computed is incorrect, or when information on the return does not match the information on a supporting form or schedule.” Not surprisingly the numbers of these types of errors are much higher on paper returns, (appx 15.3 million to 8.9 million).

For some errors, the IRS process for ERS scrutiny generally involves a tax return examiner contacting a taxpayer to correct the error; if over 40 business days elapse without a response the return is often released for processing, though is still tagged with the error code that delayed the processing.

All of this background gets us to the problem that TIGTA flagged, namely inconsistent IRS processes on e-filed returns with errors:

Our review found that IRS processes do not consistently provide taxpayers the opportunity to self-correct errors on e-filed tax returns. For example, some e-filed returns with a missing form are rejected to provide the taxpayer the opportunity to self-correct the error (i.e., attach the missing form and resubmit the e-file return) while others are accepted and sent to the ERS for manual correction by an IRS tax examiner, which suspends the return and holds the refund until the error condition is resolved.

This inconsistency can leads to later problems, as the statutory filing date of a tax return is, as TIGTA notes, “the date the IRS receives a legally valid tax return from the taxpayer.” Yet despite the statutory filing date, which is key for issues like delinquency penalties and the start date for determining when the statute of limitations on assessment expires  “e-file processes do not consider a rejected e-file tax return to be “received” until the taxpayer resubmits the rejected return and the IRS accepts it for processing.”

This rejection can lead to problems, especially if someone is e-filing at or close to the filing deadline.  To be sure this problem is mitigated by the resubmission policy that IRS has adopted. Publication 1345 discusses that process, which allows for sending a snail mail return within 10 calendar days of an e-file rejection:

If the taxpayer chooses not to have the electronic portion of the return corrected and transmitted to the IRS, or if the IRS cannot accept the return for processing, the taxpayer must file a paper return. To timely file the return, the taxpayer must file the paper return by the later of the due date of the return or ten calendar days after the date the IRS gives notification that it rejected the electronic portion of the return or that the return cannot be accepted for processing. Taxpayers should include an explanation in the paper return as to why they are filing the return after the due date.

As TIGTA suggests, the rejection of e-filed returns that satisfy the Beard test is common. If a taxpayer fails to correct the return (or corrects after the 10-day period) there is the likelihood that a return that would qualify as a return under Beard is not treated by the IRS as filed. IRS desire to maximize taxpayer self-correction of returns makes sense; it can reduce burden, speed up refunds, and avoid possible downstream costs. Yet it seems that millions of e-filed returns that IRS rejects are likely to constitute validly filed tax returns. When facing possible delinquency penalties or there are questions about the SOL on assessment it is important to consider whether the IRS previously rejected an attempted e-filed return.