About Caleb Smith

Caleb Smith is Visiting Associate Clinical Professor and the Director of the Ronald M. Mankoff Tax Clinic at the University of Minnesota Law School. Caleb has worked at Low-Income Taxpayer Clinics on both coasts and the Midwest, most recently completing a fellowship at Harvard Law School's Federal Tax Clinic. Prior to law school Caleb was the Tax Program Manager at Minnesota's largest Volunteer Income Tax Assistance organization, where he continues to remain engaged as an instructor and volunteer today.

Is IRS Appeals Using the Taxpayer First Act to Restrict Taxpayer Access?

As the name and its suggests, the Taxpayer First Act (TFA) made numerous changes to the tax code with the general intent of improving taxpayer rights and interaction with the IRS. These changes ranged from the possibly consequential (Sec. 1101’s requirement that the IRS submit a comprehensive customer service strategy to Congress, found here) to the somewhat misguided (Sec. 1203’s “clarification” on Innocent Spouse as noted here), to the outright absurd (Sec. 1406 requiring the IRS to play helpful information on their phone line while placing taxpayers on hold. I’ll take the scratchy “muzak,” thank you very much. Keith anticipated the issue before TFA with his own suggestion here.)

One provision that went largely unheralded, as far as I can tell, was the requirement that most taxpayers be provided their case file prior to meeting with IRS Appeals (codified at IRC § 7803(e)(7)). Few taxpayers (or practitioners) would oppose greater access to case files, so this seems to be a straightforward win for taxpayer rights -most pertinently, the taxpayer “Right to be informed.” IRC § 7803(a)(3)(A).

And yet in my experience IRC § 7803(e)(7) may actually result in less access to information, rather than more. How is this possible? The devil is in the details…

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To be fair, as I will argue, the devil isn’t really in the “details” of the statute. Rather, the devil is in the implementation of the statute. But that lacks alliteration and “the impishness is in the implementation” is not a commonly used phrase. Still, it is more of an “impish” problem than a devilish one. That is to say, the problem is more of an impish gremlin than a glaring devil. It causes problems precisely by going unnoticed. Allow me to explain.

Typically, when IRS Appeals asks me for numerous documents to support my client’s case, I ask Appeals for numerous documents in return. Even prior to the TFA I would ask for the administrative case file. In the past some Appeals Officers (AOs) would be confused about what I was asking for, and some would be on top of things. Post-TFA there is much less initial confusion and clarification in response to these requests, because Appeals has specifically been instructed to provide taxpayer’s case files.


Or not. In my experience, AOs reply quickly to my request for the administrative case file because they interpret it as a “TFA Request” for the case file. Indeed, that is what the subject line has read on the faxed documents I have received from the IRS over the last year.

But who cares what the IRS calls it, so long as it is the case file, right?

Not so fast. A “TFA” case file does not contain all the same information that a non-TFA case file might: importantly, it contains less. Let’s look at the statutory language to see why:

“In any case in which a conference with the Internal Revenue Service Independent Office of Appeals has been scheduled upon request of a specified taxpayer, the Chief of Appeals shall ensure that such taxpayer is provided access to the nonprivileged portions of the case file on record regarding the disputed issues (other than documents provided by the taxpayer to the Internal Revenue Service) not later than 10 days before the date of such conference.”

IRC § 7803(e)(7)(A), emphasis provided.

That emphasized parenthetical makes all the difference. One of the main things I want from the IRS is a copy of correspondence from the taxpayer to the IRS. This is because (1) I want to know exactly what it is the taxpayer has so far argued or provided for consistency purposes, and (2) because of how many IRC § 6662 penalty cases I deal with, and specifically because of the holding of Walquist, (see my take here) it is critical to know if a taxpayer responded to an automated exam, period. (In my view, this is because it takes it from the realm of being “fully automated” if the taxpayer responds to the exam, and supervisory approval of penalties arguably should then ensue.)

Further, where you are working with Appeals on a Collection Due Process case having the full administrative file (including, per the Treasury Regulation, the documents sent by the taxpayer to the IRS -see Treas. Reg. § 301.6330-1(f)(2)(A-F4)) is critical because of record review issues (see posts here and here). But when the IRS responds to your request for the case file with a “TFA case file” you aren’t getting the full picture. This is a gremlin rather than a devil because you (the practitioner) might not immediately (or ever) notice it. In my experience IRS Appeals used to provide communications from the taxpayer to the IRS in a request for the administrative file because… well, it is part of the administrative file. An important part.

Practice Tips

This whole issue came to my attention precisely because I don’t ask for the generic “case file” when I’m working with Appeals. Rather, I ask for very specific things in addition to the full administrative file. I also usually ask for clarification on whether something isn’t included in the documents Appeals sends to me because (1) it doesn’t exist, or (2) the AO just doesn’t think they need to provide it. These specific requests make the gremlin of a perfunctory TFA case file pop out pretty quickly.

As a real-life example, I recently asked for a client’s administrative case file, as well as any call log notes from the IRS pertaining to the taxpayer, and any documents submitted by the taxpayer to the IRS. Because the issue of whether my client had contacted the IRS was critical, I specifically asked Appeals for clarity as to whether the IRS did not have records of any communication, or whether Appeals simply was not planning on providing them. Appeals replied with a fax that said “TFA Case File” and provided a copy of the tax return and some automated exam notices. That was it. I responded by saying “Thank you for the TFA Case File I didn’t ask for. When you get a chance, could you send the documents I actually did ask for?”

(Disclosure, especially for impressionable students: I didn’t actually respond that snarkily. That type of attitude doesn’t help your client and runs afoul of the general proposition that you shouldn’t be a jerk to the IRS. Or anyone, really.)

My take is that this is an issue of training. Appeals Officers are essentially told in their IRM that  “taxpayers have a right to x and y documents under the TFA, so when they ask for their case file you have to give them x and y documents.” This gets internalized on-the-fly as “these are the only documents you ever have to give taxpayers, and those are the only documents you need to give on any request for additional information.”

Post-TFA, is Appeals Right to Limit the Case File?

It is not yet clear to me that IRS Appeals is taking the legal position that the TFA actually intended to constrain taxpayer access by supplanting any previous, broader taxpayer right to see the documents or communications they’ve sent to the IRS. My bet is that some individual Appeals officers may take a harder line on what practitioners are entitled to than others. When people are time-crunched and emotions are running high, I worry that the TFA could lead to more Appeals Officers digging in and saying “look, this is all I have to give you so it is all that I am giving you.”

Nonetheless, it is clearly bad policy for Appeals to hold back non-privileged case file information. The mission of Appeals isn’t to play “gotcha!” It is to try to resolve, without litigation, controversies in a fair and impartial manner that will enhance voluntary compliance and public confidence in the Service. It would be a perversion of this mission if Appeals held back information directly relevant to the merits of the case on the grounds that it isn’t covered by the TFA, though specifically requested by the taxpayer.

But beyond cutting against their own policy, it would really just amount to a waste of time since a practitioner can eventually get it through either FOIA, Branerton, or discovery anyway (at least in docketed cases). Appeals should want to resolve cases, not kick the can down the road. I would encourage the IRS to look at the TFA as a floor, not a ceiling, in taxpayer rights and services. Where necessary, Appeals should do more than just provide the documents covered by IRC § 7803(e)(7)(A) if they are serious about their mission and taxpayer rights more broadly. When holding back information they have (and that has been asked for), perhaps Appeals should ask themselves “what do you think of someone that does the bare minimum?”

A Final Plea

I have mixed feelings on the TFA, writ large. I think it was enacted with the right intentions, but I think that it would have seriously benefited from more practitioner input at an earlier stage. Yes, Congress did ask for comments in this instance but they gave a turn-around time of about two weeks (actually less) to get them in. This was covered by Procedurally Taxing at the time (here), and it is hard to imagine that the few comments that did come in were given much weight that late in the game.

Yet we’ve already seen some of the unintended consequences of the legislative language play out with innocent spouse, and I worry that this “right to the case file” may carry similar baggage. Both are issues that I think the practitioner community would have seen from the outset.

So here’s the plea. As previously noted, the TFA required the IRS to come up with a comprehensive customer service strategy. That report came out fairly recently (January 2021). When it has been fully digested, let’s not only have the IRS make some internal changes, but even possibly bring Congress back to the table. Unlike most political issues (and especially “substantive” tax law changes), changes to tax administration garners broad bipartisan support. The TFA saw essentially unanimous support from Congress, signed into law by a president that was impeached (at the time) along party lines. Going back to (arguably) the most important change to tax administration prior to TFA, you have the IRS Restructuring and Reform Act of 1998… which saw essentially unanimous support from Congress, signed into law by a president that was impeached along party lines.

At the end of the day, real respect for taxpayer rights (putting “taxpayers first”) is going to require something of an attitude change with the IRS. To me, part of this means striving to help the taxpayer, rather than looking for ways to make things difficult in the hope of scoring a default “win.” As something of a coda to that point, I’ve recently had another adventure crop up with the TFA “case file” provision. Apparently, some Appeals Officers read the statute as requiring an Appeals conference to be scheduled within 10 days of receiving the TFA file… In other words, receipt of the TFA file starts a ticking clock for the taxpayer to act quickly or miss out on a conference.

This is not at all what the statute says. Granted, Congress used needlessly convoluted language: that the case file must be delivered to the taxpayer “not later than 10 days before” the conference.  But I truly believe that the misreading of the statute (somehow seeing it as constraining the taxpayer) is much easier to do when you come from an adversarial mindset. Let’s hope, as the IRS is pulled more and more into the realm of benefits delivery, that this mindset adapts.

Nuance in Determining the Taxpayers Last Known Address – Designated Orders, November 2, 2020

There was only one designated order for the week of November 2, 2020 (Reddix-Smalls v. C.I.R., Dkt. # 17975-18L (docket with link here)). In it, Judge Gustafson ruled on whether a petitioner (allegedly) telling an Appeals Officer (AO) of a new address during a telephonic Collection Due Process hearing would legally change the individuals “last known address.”

Spoiler: it did not.

Second Spoiler: I’m still going to write about it, because there are a lot of interesting lessons to take from the order. The designated order provides a great opportunity to walk-through the statutory, regulatory and sub-regulatory guidance on point. It also gives us a chance to reflect on some of the recent legal developments in that area.


The Importance of the “Last Known Address” I teach my students that many of the important “milestones” in federal tax procedure are hit by the IRS mailing a letter. This is seen with the Notice of Deficiency -the letter which generally makes assessment possible for the IRS in deficiency cases. IRC § 6212(b) lays out where a Notice of Deficiency should be mailed to, noting that the taxpayer’s “last known address” is sufficient. The statute says effectively nothing about what someone’s last known address should be, so the Treasury Regulations and other guidance pick up the slack. The stakes are high (potentially invalidating the deficiency assessment), so determining exactly what the last known address is can be a very contentious issue.

So it is in the case of Reddix-Smalls, though not with regards to a Notice of Deficiency. In this instance Ms. Reddix-Smalls needs to show that a Collection Due Process “Notice of Determination” was not sent to her last known address. If it was sent to her last known address she arguably failed to clear the second “timeliness hurdle” (see post here) for petitioning the Tax Court, ruining jurisdiction and dismissing her case.

Dismissal would effectively result in the IRS Notice of Determination being upheld -in this, case the determination to levy. It isn’t clear that Ms. Reddix-Smalls has any great arguments as to why levy is inappropriate, but I’d note that all of the important events (CDP hearing, determination, petition) in this instance took place in 2018… and this order for dismissal came in November 2020. It is fair to say that a lot may have changed for Ms. Reddix-Smalls in those tumultuous intervening two years -perhaps even a change in circumstance that would warrant a remand for a supplemental CDP hearing.

Alas, the Tax Court cannot order a remand for a supplemental CDP hearing without jurisdiction over the matter to begin with. And the first order of business, in essentially any case, is determining if the court has the power to hear the case at all.

(As an aside, query whether Ms. Reddix-Smalls could get a supplemental hearing even without the Tax Court under IRS Appeals “retained jurisdiction.” See IRC § 6330(d)(3). I’ve written previously about the nuance of Appeals retained jurisdiction and when it can be invoked, but I’ve never tried it myself.)

Determining the Last Known Address

Usually, determining the taxpayer’s last known address is pretty straightforward: the “general rule” that the last known address is whatever was on the most recently processed tax return covers the majority of taxpayers. See Treas. Reg. § 301.6212-2(a).   On occasion the facts can get convoluted, particularly when the taxpayer has hinted to the IRS that a different address might be best. Are these hints enough to be “clear and concise notification” as required by the regulation? That can be a highly factual inquiry, and the exact contours are still being determined. For a while, filing Form 2848 with the IRS listing a different address for the taxpayer appeared to be sufficient. Then the Tax Court said “no” in Gregory v. Commissioner, 152 T.C. No. 7 (2019). Then the 3rd Circuit said “maybe” and reversed the Tax Court in Gregory (as covered here). I’d say the present state of affairs on the issue is a bit unsettled.

Obviously, the designated order in Reddix-Smalls is not precedential (neither was the 3rd Circuit decision reversing Gregory). But since we are living in an uncertain world where we must weigh specific facts and circumstances to see if they may be enough to qualify as “clear and concise” notification to the IRS, orders like Reddix-Smalls are still helpful in gauging how Tax Court judges are likely to rule.

There appear to be two potential “last-known” addresses for Ms. Reddix-Smalls. One in North Carolina (NC) and one in South Carolina (SC). Timelines matter in these inquiries, and here the timeline is as follows: in 2017 Ms. Reddix-Smalls filed a change of address with the U.S. Postal Service listing the NC address. In April 2018, however, Ms. Reddix-Smalls filed a joint tax return listing the SC address. In August 2018 the IRS sent the Notice of Determination to that SC address…

If those were the only facts here it would be an easy case: the “last known” address was the SC address, since it was most recent update with the IRS at the time of the Notice of Determination. But there is an additional wrinkle: Ms. Reddix-Smalls insists that she specifically told the AO that she changed her address to NC during her Collection Due Process hearing.

Assuming that’s true, wouldn’t that be “clear and concise” notification?

Maybe not. Though the parties dispute that fact, Judge Gustafson determines that even if Ms. Reddix-Smalls did tell the AO of the changed address that would not be sufficient.

Can that really be so? Literally telling the person at the IRS sending the letter “my address has changed” is not “clear and concise” notification of a change in address? Judge Gustafson asks the parties to explain their thoughts on this before he rules on the matter.

The IRS argument largely hinges on the fact that the AO doesn’t have access to the “Service Master File,” and therefore can’t change the address on file for the agency. Remember, the IRS is a pretty big bureaucracy: perhaps it would be unfair to impute the knowledge of a different address from one individual to the entire agency. There is a way for the AO to request that the IRS change the address agency-wide (apparently by sending “Form 2363” to Account and processing Support). But the AO didn’t fill out or send that form anywhere, so the address didn’t change -or more accurately, under IRS processes the address shouldn’t change.

This might seem a bit ridiculous to the general public: if I told an Appeals Officer at the IRS my address changed but they didn’t take any steps to affect that change in their database I’m out of luck? But the IRS argument is backed up by… IRS guidance. Specifically, Rev. Proc. 2010-06 which provides that telephonic changes of address (1) need to be done with employees that have access to the Service Master File, and (2) must include a fair amount of information about the new address and their identification. (Lingering in the background of this order are questions of whether Ms. Reddix-Smalls actually gave the IRS any address at all during the CDP hearing.)

And so, as Judge Gustafson rules, it doesn’t actually matter if Ms. Reddix-Smalls told the AO of her new address, because the AO (1) didn’t have access to the Service Master File, and (2) took no steps to get that information to IRS employees that do have such access. The Notice of Determination was sent to the proper last known address on file and was therefore effective. The petition was late based on the 30 days running from the (effective) mailing. Case dismissed.

What are some things we can glean from this ordeal?

One is a reminder of the lesson that it’s always wise to thoroughly document and memorialize (with a letter or fax) the conversations you have with the IRS. I’ve written about the importance of the administrative record in Collection Due Process before. Here, the issue arguably isn’t the Tax Court’s scope of review and whether it is limited to the administrative record, because the issue isn’t a review of the hearing, but of jurisdiction: was the Notice of Determination sent to the last known address? Yet the lesson of documenting everything holds just as true. The case would be bolstered immensely (possibly on appeal, as was done in the aforementioned Gregory v. C.I.R. decision) if there were a paper trail. A fax to the AO showing that Ms. Reddix-Smalls insisted that her address is somewhere else (and actually listing it) is simply a stronger form of “clear and concise notification” than a he-said-she-said phone call log (from the IRS AO, no less). Particularly if it was the AO that prepared and mailed the Notice of Determination (and not some other function of the IRS), one might ask why clear and concise notification to that employee shouldn’t suffice.

Relatedly, this order may serve to remind us that the IRS is a massive agency which makes it extremely cumbersome to (1) impute knowledge from one employee to the agency as a whole, and (2) get a firm grasp on exactly what authorizations any given employee has. The latter point is sometimes demonstrated in issues with settlement authority (see Keith’s post here as but one example). Here it is demonstrated in issues with changing your address on file… and the consequences that emanate therefrom.

Substantial Understatement Penalties and Supervisory Approval: Big Changes Coming?

Procedurally Taxing has been at the forefront covering the evolution of the “supervisory approval” requirements of IRC § 6751 (see posts here, here and here). The most recent post from Patrick Murray, a University of Minnesota Law student, argued that in its present, post-Walquist form, IRC § 6751 is of little help to low-income taxpayers. In a nutshell, this is because the IRS no longer needs supervisory approval for “automated” IRC § 6662(b)(2) penalties and the vast majority of low-income taxpayers experience fully automated examinations.

Mr. Murray’s post advocated for a Congressional fix, mandating that all IRC § 6662 accuracy penalties be subject to supervisory approval requirements as a way to level the playing field. I’ll reserve judgment on that, but instead ask whether a Congressional fix is actually needed for a level playing field. A scintillating footnote from a recent Tax Court opinion may reveal battle lines already being drawn on that issue.

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First off, my bet is a fair number of readers didn’t roll their eyes or do a double-take at the preceding phrase “scintillating footnote from a recent Tax Court opinion.” Please take a moment to reflect on that, as I have. Ok. Now let’s get into the fun stuff: a possible changing of the guard in IRC § 6751 supervisory approval requirements.

How do we get there? Through the idyllic (I’m assuming) town of Plentywood, Montana, its lone pharmacy and the case of Plentywood Drug, Inc. v. C.I.R., T.C. Memo. 2021-45. It is here we find that scintillating footnote I promised. Specifically, footnote 10 which provides:

“The Commissioner argues that the penalty for substantial understatement of tax at section 6662(b)(2) falls within the automatic-computation exception to section 6751. Because Plentywood Drug is the only party alleged to have under-stated its income tax and failed to carry its burden of production for the section 6751 issue, the Commissioner’s argument is moot and we will not address it.”

So we have a footnote, in a non-precedential memo opinion, where the Tax Court basically says “we aren’t touching that argument because it is moot.” You may fairly ask, “is that really ‘scintillating’?”

Yes, I’d say it is.

It is scintillating because it (potentially) represents the IRS taking a litigating position that would vastly expand the reach of Walquist. If the Plentywood examination was not fully automated this litigating position is a big deal because it takes the “automation” factor out of the equation. And there is at least some reason to believe the Plentywood exam was not automated. For one, it is a corporate taxpayer being audited on a Fair Market Valuation question -not the usual automation fodder of “our records show you have one more W2 than listed on your tax return, please explain.” For two, based on the information I was able to glean from the consolidated Tax Court dockets (Dkt. #s 17753 through 17755-16), the penalties as applied to the individual taxpayers did require (and have) proof of supervisory approval, and therefore were not automated. To me, it would be odd if the penalties against the corporation were automated but the penalties against the individuals were not.

So let’s assume this was not an automated exam. What would that mean? In essence, it would mean that the litigating position of the IRS appears to be that every “substantial understatement” penalty is “automatically computed” (and thus meets the exception of IRC § 6751(b)(2)) regardless of how the examination is initiated. In other words, Walquist would stand for “no supervisory approval needed for purely mathematical penalties, of which IRC § 6662(b)(2) is one example -regardless of whether it is a computer or a human that punches the numbers into the calculator.”

That would indeed be a step towards leveling the playing field between rich taxpayers and low-income taxpayers… by making things worse for everyone. All things considered, I’m basically fine with that.

My biggest complaint heretofore has been that under Walquist two identical taxpayers making identical mistakes, subject to identical IRC § 6662(b)(2) penalties are given different protections depending on how the IRS initiates the examination. You can see this played out, and this point made, in Bryan Camp’s post here. I think it is important that this issue be brought to the court’s attention, and especially if the taxpayer is represented.

As has been noted by both Judge Holmes in the Graev opinion itself and Professor Bryan Camp (here among other places), the statutory language of IRC § 6751 is problematic. I don’t envy the Tax Court’s role in parsing out the “real” meaning and requirements of an almost nonsensical statute -where ambiguity lies, a good lawyer will pick apart every word and nuance to advocate for their client.

And so the Tax Court has had to weigh in on timing issues (here), evidentiary issues (here), the definition of what a “penalty” is (here), and many other creative or at least plausible arguments put forth by zealous advocates.

And then you get Walquist. That case had zealots, but I’m not sure I would call them zealous advocates. The petitioners were pro se and advanced a raft of nonsense tax-protestor arguments that the Court dismissed. Maybe the outcome would have been the same with a lawyer, but I believe at the very least with competent counsel the contours of the decision would have been different. Perhaps if the IRS continues to raise the arguments it did in Plentywood we just may see that happen.

One issue I would like to see raised by counsel for taxpayers is the bizarre policy effects of Walquist. If an exam is fully automated fewer protections are offered to the taxpayer. Fully automated exams are generally limited to relatively low-dollar issues. And these issues, in turn, tend to involve middle-and-lower income taxpayers. In a nutshell, as I tell my students, high-income taxpayers get agents and low-income taxpayers get automation. And since automated penalties don’t require supervisory approval, low-income taxpayers therefore don’t get supervisory approval prior to getting hit with penalties.

To me, this has the perverse effect of protecting most those who need it least.

Pause to think about this, for a moment, while I step down from my soapbox. Accuracy penalties are largely an automatic default for the least sophisticated taxpayers, while the most sophisticated get layers of review and contemplation before determining (maybe, not conclusively) a penalty should apply. If IRC § 6662(b)(2) penalties are really just a matter of math, why should that be the case? Why should there be any discretion at all, automated exam or not, as to whether IRC § 6662(b)(2) applies when the math says it does? There are some hiccups in the statutory language of IRC § 6751(b)(2) that would cause some issues: that the penalties must be calculated “through electronic means” seems to imply that a computer is running the whole show. But as with so many other aspects of that troublesome code section, there is room for debate.

Someday I may write about (or litigate) why I don’t think IRC § 6662(b)(2) is a “pure math” question amenable to automation. But for now, I am happy that Plentywood brings that issue to the forefront, and hopeful that it arises again.

Walquist Harms The Poor: Revisiting Supervisory Approval For Accuracy Penalties

Today’s post comes from University of Minnesota Law student, Patrick Riley Murray. Mr. Murray is not actually one of my students in my Federal Tax Procedure or the Federal Tax Clinic courses. However, Mr. Murray was referred to me by a student and previous Procedurally Taxing contributor Casey Epstein (see post here), as having written on a topic I may be interested in. Casey was correct: I have a deep and abiding interest in the Walquist case and will be making an additional post on it in the near future. This post was originally written for and posted on Minnesota Law Review’s De Novo Blog and edited by Minnesota Law Review’s Online Editors. -Caleb

The Internal Revenue Service (IRS) processes more than 250 million business and individual tax returns each year. The vast majority of these returns are correctly filed and end in either additional tax paid or a refund. When a taxpayer files a return with incorrect information, the IRS will typically assess a penalty. Naturally, the IRS must adhere to statutorily imposed procedural requirements when assessing these penalties.

For example, Code § 6751 requires supervisor approval before a penalty can be assessed against a taxpayer. But a significant exception to this rule exists: if a penalty is “automatically calculated through electronic means,” supervisory approval is not required. Given the modern processes of the IRS, many penalties—including those in audits concerning the Earned Income Tax Credit, a tax break for low- to middle-income taxpayers—are assessed via computer software. The IRS claims that these accuracy penalty assessments are automatic. Meanwhile, taxpayer litigants, who are often wealthy, have been able to escape accuracy penalties by arguing that the IRS did not follow § 6751’s procedural requirements.

In short, § 6751’s application has become convoluted. The result: poor taxpayers must pay penalties that rich taxpayers can avoid through litigation. This Post discusses recent case law on the issue of supervisory approval for § 6662 penalties and argues that § 6751 should be amended to require all penalties to have supervisory approval.

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Congress added the procedural requirements—including the requirement for supervisory approval for certain penalty assessments—of § 6751 to the Code in 1998 because of concerns that the IRS was using penalties as a bargaining chip with taxpayers even when no basis for a penalty existed. § 6751 was not significantly litigated for nearly twenty years, until the Second Circuit decided Chai v. Commissioner in 2017.

In Chai, the taxpayer failed to pay self-employment tax related to $2 million in payments from a tax-shelter scheme, and the IRS assessed penalties. In Tax Court, the IRS failed to provide sufficient evidence that IRS agents obtained supervisory approval before assessing penalties. The Second Circuit held on appeal that supervisory approval must be obtained before the IRS issues a notice of deficiency. Since Chai, the Tax Court has applied an “ad hoc” treatment to § 6751 cases.

The Tax Court recently found against taxpayer litigants in Walquist v. Commissioner. At issue in Walquist was the IRS’s Automated Correspondence Exam (ACE) software. ACE automatically processes taxpayer returns. In many cases, ACE handles returns from receipt to closing with “minimal to no tax examiner involvement.” In Walquist, ACE processed the taxpayer’s 2014 tax return, assessed a § 6662 penalty, and issued the notice of deficiency automatically and without any human interaction. The Tax Court found that because the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner, the penalty was “automatically calculated through electronic means.”

Walquist has potential to harm many poor taxpayers. ACE software is designed to process taxpayer returns that claim the Earned Income Tax Credit (EITC)—a tax break for low- to middle-income taxpayers. In light of the Walquist decision, taxpayers who incorrectly claim the EITC, maliciously or not, can receive significant penalties on their tax returns without any human interaction, much less supervisory approval, from the IRS.

This seems ostensibly fair. If the IRS does not obtain approval, the taxpayer can simply challenge the penalty assessment. But this line of reasoning does not hold up when considering the resources available to tax litigants. Wealthy taxpayers often have the time and resources to challenge and litigate their penalties. For example, Graev v. Commissioner featured twelve years of litigation. And Chai v. Commissioner involved a taxpayer who made millions from their tax-shelter scheme. Poor taxpayers simply do not share that luxury. In practice, automatic penalty assessments against poor taxpayers are final, and these taxpayers have no avenue for challenging their penalties.


At least two solutions exist for this problem: (1) the Tax Court could overturn Walquist and (2) Congress could amend the tax code. Since the former suffers from a number of defects, this Post advocates for the latter solution.

The first solution, in which the Tax Court would overturn Walquist, is problematic. First, the Walquist court’s statutory interpretation of § 6751’s “automatically calculated through electronic means” exception leaves little room for argument; after all, the IRS’s ACE software automatically calculates accuracy penalties. Only a statutory interpreter willing to disregard the Code’s text completely in favor of normative concerns could advance a good faith argument to overturn the court’s statutory interpretation. It is unlikely that this strained argument would prevail at court and even more unlikely that it would survive appeal. Second, the Tax Court dismissed the taxpayer’s case in Walquist for refusing to comply with Tax Court rules. Since it is unlikely that Walquist’s litigants will see their case relitigated, this exact issue would have to come before the Tax Court again before the court could overturn its decision. This leaves poor taxpayers with no recourse for years potentially.

The second solution is far more helpful to lower-income taxpayers. This proposed solution is simple: Congress amends § 6751 to require supervisory approval for all accuracy penalties, and excuse taxpayers from their penalties if this requirement is not met. This could mechanically be accomplished by simply eliminating the exceptions in § 6751(b)(2) and by adding statutory language specifically listing out the consequences of IRS noncompliance. This solution is normatively preferable. While taxpayers should pay penalties for noncompliance with the tax code, the IRS should ensure that every step in its audit process is accurate. If noncompliance is met with severe penalties on the taxpayer’s side, noncompliance on the IRS’s side should also be met with severe penalties. And since President Joe Biden has indicated that tax reform is on his agenda, this solution could see timely implementation. Finally, this solution offers a bright-line rule for courts and the IRS to follow, leaving little room for significant litigation. Overall, this solution is vastly superior.


The recent boom of litigation surrounding § 6751’s procedural requirements has left the Tax Court searching for answers regarding supervisory approval of penalties. This has allowed wealthier taxpayers and bad actors to escape liability through litigation, leaving poor taxpayers—who often do not have the resources to litigate their penalties—at the mercy of the IRS’s whims. With tax reform on President Biden’s agenda, there is the possibility for relief. One normatively preferable solution consists of Congress amending the tax code to require supervisory approval for all accuracy penalties, excusing taxpayers from their penalties in the event of IRS noncompliance. While taxpayers should pay penalties for willful noncompliance, the Government must safeguard their rights.

Continuances in the Age of Remote Trials: Designated Orders, October 5 – 9, 2020

Months ago, I heard an interview with the NYU Professor Scott Galloway about what the world may look like post-Covid. One of the main takeaways was to think of the pandemic not as a “change agent,” but rather as “accelerant” of trends that were already underway. I’d say this holds true with the government embrace of technology in tax controversy: from the momentous leap of fax to email, to the ability to sign documents electronically (see posts here and here).

While many of these changes were long overdue and will likely remain post-Covid, not all of these changes are here to stay. Or at least not in their current form. Virtual Tax Court trials are a good example of one such change that will almost certainly not remain as the default but may well continue in some form or another. The ease of access for virtual trials (and thus its ability to efficiently resolve cases) may be too attractive to the Tax Court to abolish it altogether.

One question is how or if such changes may affect motions for continuance. To get a sense of what may happen in the future, let’s take a look at the past. Specifically, two designated orders denying such motions in calendared virtual trials.

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Tax Court Rule 133 provides that continuances are “granted only in exceptional circumstances.” While this may make it seem that continuances are extraordinarily rare, in my experience the Tax Court is generally amenable to them so long as either (1) there is a serious prospect the case will resolve without trial, or (2) the parties can demonstrate they are making progress on the case, which would make for a more resolution (be it by trial or otherwise). When I draft continuance motions, I generally try to hit on those two points, demonstrating why it is in the Tax Court’s interest (ultimately, as a matter of efficiency) to grant the continuance.

If you cannot show that you are actively engaged in the case and making a good faith effort to move things forwards the Tax Court is unlikely to grant a continuance motion. Call me a cynic, but I’d venture there are some petitioners out there that would rather have their case languish than hear what the court has to say about their case.

But perhaps the reason things have stalled are out of your control. In my experience, this sometimes arises from logistical issues in receiving the administrative file from the IRS. As I’ve detailed before, the contents of the administrative file can be a sticky issue, and also directly informs many arguments you may want to raise. (The ABA Tax Section also recently held a free webinar on the topic, which I’d highly recommend.)

Bringing things back to virtual trials, petitioners may be inclined to argue for continuances based on technological issues beyond their control. Though it is generally difficult to argue, ahead of the calendar, that you “anticipate” technological trouble that would preclude attending virtual trials, some of these may be legitimate. Where the parties have time-and-time again failed to engage or exhibit other delay tactics, however, the Tax Court is sure to look with a critical eye on these sorts of arguments. The two designated orders give, I believe, excellent examples of the limits of Tax Court patience in granting continuances.

Let’s start with Griggs v. C.I.R., Dkt. # 18035-16 (order here). First off, glancing at the docket number informs us that this case has been circulating since 2016. For context, at that time very few people on earth knew what a “coronavirus” was, and Barack Obama was handing over the keys to the White House to Donald Trump. Suffice it to say, 2016 was a while ago.

Flash forward to October, 2020 and Mr. Griggs still wants more time to get things in order. And for a while, where it seemed the case may be moving forwards, the Tax Court obliged. A continuance was granted in January 2018 after a motion for partial summary judgment by petitioners was denied. Then another continuance was granted in November 2018. Then partial summary judgment granted to the IRS…

After that, Mr. Griggs seemed less inclined to move things towards a final resolution. First, he makes numerous requests for additional time (not to be confused with continuances: see Rule 25(c)) on filing status reports. Then, almost exactly one month before the case is set for trial, Mr. Griggs moves again for a continuance. His reasons fall within the “circumstances outside my control” category: (1) the law libraries in Oregon are closed because of the pandemic, and (2) the forest fires will (somehow) keep him from attending the trial.

The Tax Court isn’t having it. The first reason is unpersuasive because it is apparently a pure substantiation case, where legal research isn’t really in play. The second reason is unpersuasive because… well, you have to actually explain why all the bad-things happening in the world specifically effect you, rather than just listing off Billy Joel style those bad things in the abstract. Mr. Griggs does not do so.

The motion is denied. Maybe our second petitioner (Ononuju v. C.I.R., Dkt. # 22414-18 (here) has better luck?

From the outset it may appear that Mr. Ononuju has a compelling case for continuance. He lives in Nigeria and, because of the pandemic cannot get a flight into the United States. Of course, since this trial is going to be virtual it doesn’t much matter where he physically is, so long as he has phone or internet access. But perhaps such access is lacking in Nigeria?

Not so, the Tax Court finds -or at least not in Mr. Ononuju’s instance. Some reasons why “I’m in Nigeria” is not sufficient, on its own, to show lack of remote access include (1) he lives in the capital city, which certainly has phone access, and (2) he was able to communicate with the IRS by phone and email while in Nigeria (where he has lived since 2017) up to then. The Tax Court is not swayed and is particularly dismayed that Mr. Ononuju didn’t even try to show up to trial and express his concerns with phone or email access so that arrangements could be made.

In my experience, the Tax Court is very understanding when these issues are expressed in good faith. And reading between the lines, the “good-faith” of Mr. Ononuju seems to be called into question here. Although Mr. Ononuju doesn’t show up for trial, his wife does and testifies that he was presently providing medical care in rural areas to people in need.

How noble! Only the Tax Court doesn’t find her testimony credible, so maybe not. A very brief look at taxes at issue might give some hints as to the credibility gaps.

Mr. Ononuju founded and was president of the non-profit “American Medical Missionary Care, Inc.” Again, how noble! Except, at least according to the IRS, Mr. Ononuju engaged in “excess benefit transactions” under IRC § 4958. I don’t work with non-profit tax issues, but under IRC § 4958(c), these appear to be transactions where someone with control over the non-profit uses the non-profit for undue personal gain. The penalties are stiff: a 25 percent excise tax on the prohibited transaction under the “first-tier,” and a 200 percent(!) second tier excise tax if you don’t correct the excess benefit transaction -which apparently Mr. Ononuju never did. I have no insight on whether these taxes were appropriate, or the merits of the case generally, but things seem to have been unraveling for Mr. Onounju: Michigan revoked his medical license at about the same time the IRS examination appeared to be going on.

The IRS asserted a deficiency of over $1.5 million for 2014. Usually that’s a large enough number to keep people engaged. And though Mr. Ononuju was for a time, that appears to have stopped right when the parties got to fact stipulation. After that, radio silence…

Much of Tax Court litigation occurs without the active involvement of the Tax Court itself. Unlike in federal district court, the parties are mostly entrusted to work out the facts between themselves without formal discovery -or at least try to, before getting the court involved. Trial can then largely be reserved to those factual issues the parties could not (reasonably) agree on. But woe onto those who do not engage in the stipulation process, and then ask the Tax Court to postpone the trial. That the (eventual) trial will be virtual doesn’t really play into that equation.

And so we have yet another denied motion for continuance.

To me, virtual trials will just be an extra tool in the Tax Court toolbox: one that could especially benefit places like Minnesota, where the trials are infrequent. As the Tax Court shifts back to on-site calendars, however, I think the possibility of virtual trials could be reason for the Tax Court to be more comfortable in granting continuances -so long as the petitioner is engaged in the process. Imagine the petitioner shows up to calendar after largely being uncommunicative and makes a motion for continuance that very day. Maybe they have a lot of really good reasons for being uncommunicative, and maybe it seems like their case has some merit. In places like Minnesota, Tax Court judges are in a bit of a bind in those instances. If they grant the motion to continue it might not be set for trial for another 6 months to a year. Usually, the Tax Court puts the case on “status report” track to try and keep the parties engaged in the interim.

Virtual trials could go one step further, particularly for those parties that are actually engaged in the process, and perhaps even more so for those that are linked with pro bono counsel at calendar call. Now, instead of scrambling to put together a case that day or week, theoretically pro bono counsel could make a motion for continuance with the understanding that a virtual trial will be held in two or three months -usually enough time to actually sort things out, without being so far in the distance that one of the parties disappears.

For petitioners like Mr. Griggs and Mr. Ononju where continuances may just be a tactic of indefinite delay, they can and should be denied -virtual trial or not. But for engaged petitioners that just need some more time (or assistance from free counsel), the availability of virtual trials may actually provide more cushion for continuances to be granted -at least from the perspective of efficiently resolving cases.

Accepting Gifts from the IRS: Ethical Considerations (Part Two)

Previously, we discussed the two categories of IRS “gifts” that taxpayers cannot accept: clerical gifts and purely computational gifts. We left, however, with the cliffhanger that computational gifts may become “conceptual” gifts, which attorneys often can accept. Today, we’ll look closer at what a conceptual gift is and whether it is what was at issue in the Householder case (covered here).

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Conceptual Gifts

Each step away from the strictly arithmetic computational gift takes you closer to the conceptual. Facts and circumstances are critical in determining which category the gift best falls into. So much of tax calculation involves the interplay of disparate statutes and facts, which may or may not have been explicitly covered in the settlement and negotiation. What first appears to be a matter of computation can often be a matter of concept: for example, the failure of the IRS to raise an issue that at first seemed ancillary but ultimately is determinative.

For example, imagine you are settling a deficiency case where your client filed their return late. Both parties have agreed on the deficiency amount, but never really discussed (or settled on) the exact date the return was filed. The IRS prepares a settlement document that reflects the deficiency agreed on but has a lower IRC § 6651(a)(1) late-filing penalty than you expected. Is this a computational error or a conceptual error?

At first blush, failure-to-file penalties seem like basic arithmetic: essentially, you look at the total amount of tax that should have been reported (and paid) and multiply that by 5% for each month the return is late. In the above hypothetical you’ve reached a determination of the amount of tax that should have been reported when you settled on the deficiency amount. But it isn’t clear that you ever discussed or determined exactly when the return was filed -that is, how late the return is, and by consequence how many months the penalty applies. That value could be subject to reasonable dispute. Exactly when a return is “filed” can be contentious. If the return was truly “late-filed” the issue would be when the IRS received it… but even that date isn’t always clear, especially post-Fowler (see coverage here).

Reverse engineering the late-filing penalty calculations may help in this case: how many months does the penalty amount proposed by the IRS equal? Is it a mathematically impossible number under the statute? (IRC § 6651(a)(1) rounds each fraction to a full month, so if you are 32 days late it is the equivalent of two months.) If so, it is likely a computational error.

Likely a computational error. But not definitely.

Again, conceptual errors may linger behind even the most seemingly mathematical mistakes. The IRS could conceivably have decided on a penalty amount that doesn’t immediately appear to add-up. For example, maybe the parties agree that the return was three months late, but the IRS believes there are significant hazards of litigation on a “reasonable cause” argument. In that case, the IRS may settle on a penalty that doesn’t otherwise make mathematical sense: a penalty of only 60% of the amount due for a three month-late return, accounting for the 40% chance that the petitioner may prevail on a reasonable cause argument in court.

The thing is, as a matter of negotiation the IRS pretty much always has discretion to settle on dollar amounts that won’t “make sense” in a winner-takes-all application of the Code. Left unbounded, the unscrupulous tax attorney could always say, “it wasn’t an arithmetic error: they were just scared I might win!” This line of argument should not always be availing. Whether an attorney can shoehorn a computational error into the conceptual category depends on the facts and circumstances of the case at issue, and the actual conduct of the parties in reaching their settlement.

First though, it is important to recognize why tax attorneys may be so tempted to categorize gifts as “conceptual” in the first place. The biggest reason? These are the gifts you can (in some sense, “must”) accept from the IRS. They are (generally) client confidences that do not raise to the level of misrepresentation to the court. Unless the client wants you to disclose the issue, you shouldn’t. Admittedly, different people in the tax world have different views on your responsibilities to the client and tax administration more broadly. The 2020 Erwin Griswold Lecture gives an interesting overview of the opinions of some prominent tax personalities on that point.

ABA Statement 1999-1 uses the example of a Schedule C deduction to illustrate. In the example the parties eventually agree that the deduction should be allowed, but counsel for the taxpayer believes (secretly) that the deduction likely should be due to passive activity under IRC § 469, and therefore wouldn’t benefit the client. The IRS doesn’t raise this issue, and neither does counsel. ABA Statement 1999-1 advances this as a “conceptual” error: counsel must not disclose unless their client expressly consents to their doing so.

To me, this is a roundabout way of asking whether the conceptual error might not be an “error” at all. As the ABA Statement notes, passive activity issues are highly factual and “subject to some reasonable dispute.” That seems less like a conceptual “error” on the IRS’s point, and more like a conceptual “weakness.” In the ABA’s example the wiggle room is in the reasonable dispute on a highly factual question of law. But that isn’t always how conceptual errors work, particularly when you “know” the key facts at issue.

For example, imagine the IRS audits your client claiming their niece as a qualifying child for the Earned Income Tax Credit. All the IRS is putting at issue is whether the niece lived with your client. Later in the process, you learn that the real problem with your client’s return is that they are legally married and needs to file married filing separate (which disallows the EITC). The IRS, however, doesn’t think to raise this issue. Note that this is essentially what happened in Tsehay v. C.I.R., discussed here. Even though that may be a “conceptual” error you still are not completely off the hook. I would argue that you cannot enter a decision with the court failing to correct that mistake. Recall your obligations to the court under MRCP 3.3 and note especially Rule 3.3(a)(2): the prohibition on failing to disclose adverse controlling legal authority.

In sum, the only time you may be completely free is where it is a conceptual “weakness” rather than an outright error: those instances where you could argue “maybe, just maybe, it wasn’t a mistake at all.” Let’s see if that’s what happened with the Householders.

As Applied to the Householders

The gift to the Householders was in the form of a very messy Notice of Deficiency. Most pertinently, it involved the transformation of a gain (reported by the taxpayer) into a rather large, favorable loss that never seems to have been claimed by the taxpayer at all. The Notice of Deficiency explanation illustrates the confusion: “It is determined that the amount of $317,029 claimed on your return as a loss resulting from the sale of your business is allowable.” The problem is that loss was not claimed on the return.

How did this mistake come to be? Was it from dueling legal theories for calculating the gain on the sale? I am operating from imperfect information, but the order would suggest otherwise. The working theory is that the IRS revenue agent was looking at an unsigned Form 1040 that had been submitted during examination negotiations, and not the actual Form 1040 that had been filed.

One may be tempted to call this a “clerical” mistake: a typo transposing numbers from the actual filed return and one that was just floating in the revenue agent’s file. But one can also imagine facts that would shift this into the world of “conceptual” errors. If there was a return floating around the revenue agent’s file that took the position there was a $317,029 loss, it is conceivable that the IRS simply agreed with that position. How are you to know if the IRS agreement was inadvertent? More facts would certainly be needed surrounding the transaction at issue to determine if it were a conceptual or clerical error.

A core question Householder raises is whether by filing a petition and invoking the power of a tribunal (and thus MRPC Rule 3.3), you are under any sort of obligation to correct errors on a Notice of Deficiency: computational, clerical, or otherwise.  A secondary question is whether silence on such a mistake is the same as prohibited “misrepresentation” to the court. I don’t think it is always so simple as to say “it’s not my job to fix the IRS’s mistakes.”    

In any event, by the time Householder gets to the Tax Court, Judge Holmes is essentially handcuffed in getting to the right number. Particularly where settlement is done on issues rather than bottom line numbers, it appears that silence on an error concerning how those issues will ultimately “add up” under Rule 155 computations is not going to be upset by the court. See Stamm Int’l Corp. v. C.I.R., 90 T.C. 315 (1988).

But that’s not what this foray into ethics is all about. This is not about what the Tax Court can do, but what a tax attorney should do under their professional obligations. I certainly do not have enough facts to know whether Householder involved conceptual, computational, or clerical mistakes. I do know that these sorts of gifts raise all sorts of ethical issues and are not as fun to receive as one may think.

Accepting Gifts from the IRS: Ethical Considerations (Part One)

Previously, I wrote about the strange case of Householder v. C.I.R (here). As a refresher, the Householders tried to take about half-a-million dollars in nonsense deductions for their horse breeding/leasing “business,” and the Tax Court disallowed them. This, of course, resulted in a $0 deficiency after running Rule 155 computations.

Wait, what?

Yes, that’s right: there was no deficiency for the Householders even after “losing” on a half-million dollar deduction because the IRS made a serious mistake in their Notice of Deficiency. Essentially, the IRS “gifted” the Householders a tax loss unrelated to the one at issue before the court. In the previous post we mostly looked at whether the IRS could take back or otherwise undo their gift. This time, we’ll look at ethical considerations for counsel in accepting these gifts.

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It took all my willpower not to name this blog “Emily Post’s Guide to Accepting Gifts From the IRS.” However, the real concerns for counsel in these situations are less matters of etiquette and more the competing obligations of confidentiality with your client and candor to the court.

As a human in the world, I might think morality dictates I should tell the IRS of an erroneous “gift” so they can (presumably) rescind it. But as a lawyer in the world, professional rules dictate otherwise- something that may be thought of as a “loophole” in morality. (I can’t help myself: I was a philosophy major with a focus on applied ethics and I’m still paying off those loans. Any reference I can make to something I learned in undergrad eases the pain.)

Without being able to heavily rely on our gut moral compass, it can be difficult to know what is required of you as a lawyer on ethical issues. Lawyers have to think in terms of what “is or isn’t” in accordance with the Model Rules of Professional Conduct (MRPC). And even within the constrained universe of the MRPC it can be difficult to know what your ethical responsibilities are: as the Minnesota Rules of Professional Conduct state, these are “rules of reason.” See MRPC “Scope” [14]. In most situations attorneys must work backwards from the general principles of the MRPC to arrive at an answer.

Fortunately, there is an ABA Statement almost directly on point for the sorts of issues at play in Householder. This is ABA Statement 1999-1.The money quote from that statement is as follows:

“A client should not profit from a clear unilateral arithmetic or clerical error made by the Service and a lawyer may not knowingly assist the client in doing so. This is not the case, however, if the computational error is conceptual, such that a reasonable dispute still exists concerning the calculation.”

The ABA Statement creates a typology of “gifts,” each with different characteristics and ethical considerations. The differences are important primarily in how they determine what duties you owe the client, the IRS, and the court. Those different varieties are (a) computational gifts, (b) clerical gifts, and (c) conceptual gifts. Let’s take a look at each before figuring out which one the Householders received.

Clerical Gifts

Let’s begin with the easiest one to classify and respond to: clerical gifts. These can be thought of as typos, and they are not the sort of gifts you are allowed to accept. If my client and the IRS settle on a refund of $1,000 and the IRS types up a decision document accidentally listing a refund of $100,000 my role is clear: Let the IRS know of the mistake. I don’t even need to consult my client on that. The decision document would be entered in court and failing to correct this mistake would be in violation of my duty of candor to the court. MRPC 3.3.

You might be thinking to yourself, “but what about your duty to the client? Shouldn’t they get the final say as to whether to accept this payday since the mistake is a client confidence?”

Not so. Where the court is involved, such client confidences are explicitly overruled by MRPC 3.3(c). In fact, because you’d already reached a settlement amount with the client and IRS, you don’t even need to disclose the issue to your client: you have implied authority to make the fix on your own. See MRPC 1.6(b)(3). As we’ll see with the other varieties of gifts, this issue of maintaining a client confidence can be a serious sticking point.

If the matter didn’t involve entering a decision document in court (and therefore candor towards a tribunal), the answer may be different. In that case, you’d want to have a long chat with the client about the criminality of cashing a government check they aren’t entitled to. And as a tax lawyer you’d probably want to drop the case because of Circular 230 concerns. But that isn’t what we’re dealing with for the purposes of this blog. For now, playing the role of Emily Post, if the IRS gives you a clerical gift, one must politely say “I could never accept such generosity.”

Computational Gifts

Computational gifts may be “squishier” than clerical gifts and entail a broader range of mistakes. On one end of the spectrum the mistake may be simple arithmetic: 2 + 2 = 5. This isn’t a far-cry from a clerical mistake, and identical ethical considerations apply: you cannot accept such generosity, and you must disclose (if in court). Most of the time, however, the arithmetic isn’t so cut-and-dry. What if the issue isn’t failure to correctly add two numbers, but failure to consider a code section that would introduce another variable to the equation? In other words, what if the correct computation is 5 + 3 x 0 but the IRS doesn’t recognize a law providing the zero multiplier, and only adds 5 + 3? Computational, to be sure, but not strictly so…

Which leads us to the final category: “Conceptual Gifts.” These are the gifts attorneys want to receive from the IRS, because in some circumstances they can actually accept them. Was the Householder’s erroneous Notice of Deficiency one such conceptual gift? We’ll take a deeper look at what exactly distinguishes conceptual gifts from purely computational ones in the next post.

Tax Court Rule 155 and Gifts from the Service

From time to time it can feel as if the IRS is giving your client a bit of a gift. It could be in the form of the IRS settling on weak arguments -perhaps with inflated fears over the “hazards of litigation” the facts present (see post here). It could also be in the form of the IRS informing your client of deductions or credits they are eligible for but never actually claimed -something I have seen in practice on numerous occasions.

But the IRS may also make an inadvertent “gift,” less charitably described as an “error.” And when this happens in your client’s favor it raises all sorts of ethical and legal issues. This post will focus only on the legal issues, and particular the timing of the IRS’s “gift” and when the IRS is no longer able to take it back. These valuable and interesting lessons were issued as (presently on hiatus, but hopefully to be revived) Designated Orders the week of September 7, 2020…


The designated order at issue stems from a rather old and interesting case: Householder v. Commissioner, Dkt. # 6541-12 (order here). The Tax Court issued its findings of facts and an opinion on the case way back in August, 2018 (T.C. Memo. 2018-136, here). From that time until the order above, however, no decision could be entered because the parties could not agree on their Tax Court Rule 155 computations. Note that in deficiency cases the Tax Court is required to issue a decision that directly addresses the amount (if any) of the deficiency -which isn’t always done through the opinion. This exact issue was very briefly discussed in the only other designated order of the week, Hopkins v. C.I.R., Dkt. # 19747-19 (order here).

Nonetheless, when the Tax Court issues an opinion that addresses all the substantive legal issues the final deficiency should be a fairly simple matter of math. As we have seen before (see Keith’s post here) when dealing with Rule 155 there is little room for gamesmanship, and even less room to raise new issues. Ultimately, as we’ll see, that latter concern dooms the IRS. But before getting there let’s take a second to ponder all the work that went into this case prior to the decision finally being rendered.

The Householders are highly educated, wealthy and successful. Scott Householder is adept with financial planning, and Debra Householder, in addition to having a Ph.D. in psychology, has a lifelong affinity for horses and horse riding. So it seems a perfect marriage of passions and proclivities when they are approached with an investment opportunity involving horse breeding and leasing…

If you’ve ever read any tax case on “hobby-losses” (the colloquial term for the IRC § 183 prohibitions) you probably know where this is going. Rich people apparently love horses. For some it may be genuine (like Debra’s). For others it may be because horses tend to generate (potentially) tax-deductible business losses. It is also almost always the case that the IRS wins in arguing that these losses are not actually businesses with a profit motive, but instead hobbies. This is true even though Congress has created a less demanding presumption for showing a “business motive” specifically pertaining to the “breeding, training, showing, or racing of horses.” IRC § 183(d).

The mechanics of the Householder’s arrangement was a bit more complex than the usual “rich-people owning horses and pretending it’s a business” scheme, but not by much. The entity that pitched and ran the horse-leasing enterprise (“ClassicStar”) to the Householders yielded at least five separate Tax Court decisions where no loss was allowed because the horse breeding/leasing was not engaged for profit. If anything, the ClassicStar scheme is more bald-faced and upfront as a tax scam than most. I encourage people to read the facts of the opinion: ClassicStar all-but-asks the Householders “how much of a loss do you want?” in multiple years.

Yes, ClassicStar advised that the Householders take all sorts of business-like steps with this investment (create an LLC or S-Corp! have a separate bank account just for this business! spend 100+ hours on meetings and such!), but the writing is on the wall: this is a sham, and almost certainly not a business that is being operated for profit by the Householders. As but one more in a long line of examples, the Householders didn’t even know what specific horses they’d be breeding/leasing when they paid the money: knowing the horse you’re forking over hundreds of thousands of dollars for is usually something you care about when trying to make money. Bad facts (there are many more in the opinion, including that one of the horses was castrated and thus not particularly suited for breeding), make for very dim prospects of deducting the expenses.

But it goes beyond the IRS just auditing the Householders on a bad hobby loss. ClassicStar was eventually raided by the IRS and completely shut down. Some of the ripple effects included $200 million in tax fraud charges and $65 million in damages to certain defrauded investors. This was a widespread scam, and it did end up costing a lot of other people quite a bit of money on what they appeared to genuinely believe was an investment opportunity.

But what about for the Householders, who only ever really seemed to care about generating inflated tax losses in the first place? Almost incredulously, the Householders continued to argue in Tax Court that they were engaged in the business for profit. But Judge Holmes has no problem shooting this down: the system works!

Almost. Hold that thought for now.

There is an alternative argument that the Householders make, which is that the money they paid to ClassicStar should be deductible as a “theft loss” in 2006 when it became clear they could not get their “investment” back.

I want to pause to consider the chutzpah of this argument. Imagine you spend approximately $500,000 on a complete scam, that you know is a scam, but have been assured that the scam will generate $2 million in tax losses. It later turns out that the scam generates $0 in tax losses… because it is a scam. You want your $500K back from the scam artist but, having been shut down by the IRS for being a scam artist, they have no money left to pay you with. Should you get to take a loss of the $500K as a “theft” because the scam was exactly what it sounded like: a scam?

The Tax Court, again, says “no” though for different reasons. There was also an exchange of stock in this case, and the Householders want to argue that it was worth very little, due to “discounts in marketability.” The Householders are likely wrong on this as a matter of fact, but they also raise this issue too late: for the first time, on brief. Judge Holmes determines that the Householders didn’t really “lose” the money they put down in the first place. If anything, they likely came out slightly ahead. You need to lose something to have a theft loss, and the Householders didn’t lose anything here. So no business deduction and no theft loss: the only real issues in play. The system works!

Not quite. For, as we will see, despite their ludicrous legal arguments and return positions the Householders end up having no deficiency. A gift from the Service. This is where we arrive at the designated order, several years later.

I’ve noted before how important it is to “raise all of your arguments” (here). Petitioners must be wary of failing to assign error to items in a Notice of Deficiency they would like to dispute. Generally failing to do so means that it is conceded (Tax Court Rule 34(b)(4)), unless (1) you amend the petition, or (2) are able to argue that it was tried by consent. See Tax Court Rules 41(a) and (b) respectfully.

But the IRS runs similar risks. In this respect, it is helpful to conceptualize the Notice of Deficiency (NOD) as the IRS’s complaint. If the IRS fails to raise an issue in a NOD, they can generally add it to the “complaint” later, with the Court’s consent. However, even if the Court allows, this carries the potential complication that IRS position does not have the presumption of being correct -as it would if it were included on the NOD. See Welsh v. Helvering, 290 U.S. 111 (1933) and Tax Court Rule 142(a).

The IRS gift to the Householders goes one step further than that usual, fairly excusable mistake. Rather than forgetting to bring up an issue in the NOD, the IRS actually creates a new, very taxpayer friendly one. Somehow, likely in a mix-up of papers, the IRS agent drafting the NOD gave the Householders a loss of $317,029 (on an issue that had nothing to do with the horse fiasco), where the Householders had actually reported a gain of $145,000.

The Householders, on seeing this gift in the NOD, kept their mouths shut. In other words, they didn’t assign it as an error on their petition. This effectively meant that the numbers were conceded, and not properly before the court. Note, again, the IRS could have recognized this at numerous points up to the trial and properly raised the issue. But the IRS was in tunnel-vision mode with this case and didn’t see their own error on the NOD.

By the time it becomes obvious that there was a mistake the train had left the station. All the parties had left to do was run through the computations based on the items as reflected in: (1) the original return items that weren’t challenged in the NOD, (2) the NOD as conceded or agreed upon, and (3) the unagreed items as determined by the Tax Court. The magical gift of converting a $145,000 gain into a $317,029 loss was in the second category: agreed upon by the parties, as evidenced by the NOD and the lack of any mention of it in the pleadings, stipulations, or any other point of the trial up until the awkward moment the IRS had to add things up and find that their win in court resulted in a $0 deficiency.

I feel for IRS Counsel seeing this far too late and trying desperately to find a way to the right outcome. Valiantly, the Service tries a motion for reconsideration (Rule 161), but to no avail. These motions are pretty uphill battles in any case (see Keith’s post here), but a motion for reconsideration is not appropriate for instances where the Court didn’t make a mistake, but you did. For more, you can see my post on the three usual “flavors” of a motion to reconsider here.

So at the end of the day through the Householders agreeing to accept the IRS gift they walk away with no deficiency in case where the Court found they took some absolutely nonsense deductions. A pretty unsatisfying outcome for everyone but the Householders I’m sure. But likely the correct one as a matter of Tax Court procedure.

In a follow up post I’ll look a bit further at a question that may be on people’s minds: Can you, as an attorney, ethically accept that kind of a gift from the IRS in a court proceeding?