Working Through an Employer’s Failure to File Form W-2 or 1099 with the IRS

We welcome guest blogger Omeed Firouzi to PT. Omeed is a Christine A. Brunswick public service fellow with Philadelphia Legal Assistance’s low-income taxpayer clinic, and he is an alum of the Villanova Law Clinical Program. His fellowship project focuses on worker classification. In this post, Omeed examines a recent case where the taxpayer unsuccessfully sought relief under section 7434 for her employer’s failure to report her compensation to the government at all. Litigation in this area is likely to continue. Christine

Tax season is upon us so I would be remiss if I did not cite fellow Philadelphian Ben Franklin’s famous maxim that “in this world nothing can be said to be certain, except death and taxes.” But whether you are filing your return as soon as possible or at 11:59 PM on April 15, there is one thing that is uncertain for many taxpayers: whether your employer filed an information return.

As we have seen in our clinic at Philadelphia Legal Assistance and more broadly, employers are increasingly not filing income reporting information returns with the Social Security Administration (SSA) and the Internal Revenue Service (IRS). The Internal Revenue Manual, at IRM 21.3.6.4.7.1, describes the proper procedure for IRS employees to follow should a taxpayer not receive an information return. The IRS website also provides tips and tools for how taxpayers should proceed in such situations.

Under the Internal Revenue Code and regulations promulgated under the Code, employers could be held liable – and subject to penalties – for failure to file correct information returns. However, the IRC and its accompanying regulations lack a clearly defined legal recourse for individual taxpayers when the employer fails to file any information return at all. No explicit cause of action exists for workers in this predicament. Recently, a taxpayer in New York unsuccessfully tried to make the case that 26 U.S.C. Section 7434 encompasses this situation.

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The statute states, in part:

If any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, such other person may bring a civil action for damages against the person so filing such return.

This statute has been the subject of several previous Procedurally Taxing posts. As these posts described in detail, courts are in consensus that the statute at least encompasses an employer’s willful misstatement on an information return of the amount of money paid to a worker. The legislative history of Section 7434 reveals that when Congress drafted the legislation in 1996, its authors were concerned with the prospect of “taxpayers suffer[ing] significant personal loss and inconvenience as the result of the IRS receiving fraudulent information returns, which have been filed by persons intent on either defrauding the IRS or harassing taxpayers.” 

The case law is split on whether misclassified taxpayers can use Section 7434 to file suit against their employers for fraudulently filing a 1099-MISC rather than a W-2, if the dollar amount reported is correct. No circuit court has ruled on the issue but most courts have followed the lead of the U.S. District Court for the Eastern District of Virginia and its Liverett decision that found that Section 7434 does not apply to misclassification.

However, one aspect of Section 7434 where there is judicial consensus is that the statute does not encompass the non-filing of an information return.

The U.S. District Court for the Eastern District of New York recently joined the chorus of courts on this issue. In Francisco v. Nytex Care, Inc., the aforementioned New York taxpayer argued that her former employer, NYTex Care, Inc., violated Section 7434 by “failing to report payments made” to the taxpayer and other workers. The facts of the case are straightforward. Taxpayer Herlinda Francisco alleged NYTex Care, a dry cleaning business, “fail[ed] to identify [her] and other employees as employees” by failing to file information returns for tax years 2010, 2011, 2012, 2013, 2014, 2015, and 2016. Francisco filed suit under Section 7434 alleging that NYTex “willfully and fraudulently filed false returns…by failing to report” employees’ income.

The court principally cited Second Circuit precedent, set in Katzman v. Essex Waterfront Owners LLC, 660 F.3d 565 [108 AFTR 2d 2011-7039] (2d Cir. 2011) (per curiam), in dismissing the case. Katzman established that Section 7434 “plainly does not encompass an alleged failure to file a required information return.” In Nytex, the employer “did not report payments made” to the taxpayer and other employees but the court found that Section 7434 was not the appropriate remedy.

More broadly, the Nytex court examined the plain language of Section 7434, its legislative history, and other relevant case law in foreclosing this claim. The plain text of the statute, the court noted, necessitates a filing by definition; there must be a filed information return in order for it to be fraudulent. The court also looked to Katzman’s parsing of congressional intent for guidance; in Katzman, the Second Circuit ruled explicitly that “nothing in the legislative history suggests that Congress wished to extend the private right of action it created to circumstances where the defendant allegedly failed to file an information return.”

Further, the court even relied upon another case the same plaintiffs’ attorney brought in the Southern District of New York. In Pacheco v. Chickpea at 14th Street, Inc., the plaintiff there also brought suit under Section 7434 on the basis of the failure of their employer to file information returns but the Southern District “found [that situation] was not covered by the statute.” Ultimately, the Nytex court granted the Defendants’ motion to dismiss for failure to state a claim upon which relief can be granted because the court found no cognizable claim for alleged failure to file an information return under Section 7434.

The result in Nytex leaves it frustratingly unclear what remedies exist for workers who find themselves in this taxpayer’s predicament. Had the employer here actually filed a 1099-MISC with the IRS, a potential argument could’ve been made about misclassification and whether that is encompassed by Section 7434. There is more division in the courts about that issue as opposed to the question posed in Nytex. Had the employer willfully overstated the amount the taxpayer was paid, the court could’ve found a clear Section 7434 violation, based on the reporting of a fraudulent amount.

Of course, neither of those things happened here. Instead, there is an aggrieved taxpayer ultimately unable to rely on a statute that is both ambiguous and seemingly limiting all at once. Practically, she is left with no clear way to sort out her own tax filing obligations when no information returns were filed. The court interestingly does not identify an alternative course of action, or judicial remedy, the taxpayer could seek.

In relying on congressional intent, the court leaves the reader wondering if Congress ever envisioned that an employer’s failure to file an information return could cause “significant personal loss and inconvenience” to the worker. If it means a frozen refund check as part of an IRS examination, there is certainly loss and inconvenience there. As Stephen Olsen described at length previously, courts have deeply examined the statutory language in terms of whether the phrase “with respect to payments made” only modifies “fraudulent” or if the information return itself could be fraudulent even if the payment amount is correct.

That discussion raises an interesting question as it relates to Nytex: if a court found an actionable claim for non-filing under section 7434, how would it determine whether the failure to file was fraudulent or whether there was willfulness in the non-filing? Since there would be no information return, would the court be forced to look at what kind of regular pay the taxpayer got to ascertain what the information return likely would’ve been?

Then, the court would have to find that there was “willfulness” on the part of the employer, not merely an inadvertent oversight. To make matters more complex, the court would have to likely wrestle with how there could be a willful act in a case where the employer did not even act at all. If a court found willfulness, a potential argument could be that a non-filing is analogous to filing an information return with all zeroes on it thus leading the court to say it is, in effect, fraudulent in the amount.

For now though: what can a taxpayer do in such a situation? When employers fail to provide or file information returns, the IRS recommends that workers attempt to get information returns from their employers. If that fails, the IRS advises workers to request letters on their employer’s letterhead describing the pay and withholding. Should an employer not comply with these requests, the IRS can seek this information from an employer while taxpayers can file Substitute W-2s attaching other proof of income and withholding – such as bank statements, paychecks, and paystubs. If a taxpayer got an information return but the employer never filed it with the government, that might ease the burden on the taxpayer but the IRS will still seek additional verification.

Even then, taxpayers could get mired in lengthy audits and examinations all while waiting for a critical refund check they rely on to make ends meet every year. We have seen this pattern play out in our own clinic and I suspect as it befalls more taxpayers, there may be either a congressional or judicial reexamination of Section 7434 or another effort to address the problem of non-filing of information returns.

Logic Loses in Taxpayer’s Effort to Recover Attorneys’ Fees

We welcome first-time guest blogger Professor Linda Galler to PT. Professor Galler is a co-author of the chapter, “Recovering Fees and Costs When a Taxpayer Prevails” in the forthcoming edition of Effectively Representing Your Client Before the IRS. Among Professor Galler’s many consulting, teaching, and scholarly pursuits, she directs the tax clinic at Hofstra University’s Maurice A. Deane School of Law.

In this post Professor Galler examines a recent decision denying a taxpayer fees and costs against the IRS. (Bryan Camp also covered the case here.) For those galvanized to learn more about qualified offers after reading this post, I recommend guest blogger Professor Ted Afield’s post on nominal offers, and Stephen Olsen’s grab bag of cautionary tales. Christine

Taxpayers rarely recover attorneys’ fees in tax cases despite the existence of a statute specifically providing for such recoveries. The Tax Court’s recent decision in Klopfenstein v. Commissioner, TC Memo 2019-156 (Dec. 9, 2019), is an example of why: the statutory requirements and the manner in which they are interpreted are overly exacting and counterintuitive. Klopfenstein involved a settlement of assessed penalties at Appeals for ten cents on the dollar – a 90 percent reduction in an assessed penalty – clearly raising the question of whether the government’s position in the case was substantially justified. Yet, in an opinion that relied heavily on established precedent, the court concluded that the IRS never took a “position” within the meaning of the statute and therefore that the taxpayer could not recover attorneys’ fees.

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This essay does not argue the merits of recovery in Klopfenstein or in general. Clearly, there are policy arguments on both sides. Rather, the point is to both demonstrate the fruitlessness of seeking attorneys’ fees and to commend the taxpayer’s attorneys for having tried nonetheless.

Mr. Klopfenstein’s court filings describe him as an “investor, investment banker, and merchant banker” who “earned an MBA in finance and accounting from Emory University” and “is licensed as a CPA and as an investment banker.” In 2005, the IRS commenced a tax shelter investigation for 1998 through 2001 with respect to entities that Mr. Klopfenstein controlled. In November 2014, Exam issued a Notice of Proposed Adjustment (“NOPA”) asserting that Mr. Klopfenstein was a material advisor who failed to disclose reportable transactions as required by section 6111. The NOPA referenced more than 24 alleged transactions, which the IRS asserted should have been registered as tax shelters, and proposed penalties under section 6707 in excess of $1.6 million.

Mr. Klopfenstein timely requested that his case be considered by Appeals, which assigned the case to an Appeals Officer (“AO”) in October 2015. The penalties were assessed in March 2016 and the IRS immediately began collection efforts, culminating in the filing of notices of federal tax lien in two states. Meanwhile, the AO held a pre-conference meeting with Mr. Klopfenstein, his attorneys and Exam personnel in June 2016 and a settlement conference in August. A settlement was reached under which Mr. Klopfenstein agreed that he was liable for a section 6707 penalty of approximately $170,000 for 1998 and that he was not liable for penalties in an any other year. The settlement was memorialized in a closing agreement, which was returned to Mr. Klopfenstein, signed, on November 30, 2016. The following month, the IRS abated more than $1.4 million of the assessed penalties, roughly 90% of the original assessment.

On February 27, 2017, Mr. Klopfenstein submitted a request for reasonable administrative costs (attorneys’ fees) under section 7430(a)(1), contending that he was a “prevailing party” and therefore was entitled to an award for attorneys’ fees and costs incurred during the administrative proceeding. The IRS denied the request and Mr. Klopfenstein filed a petition with the Tax Court seeking review of the IRS’s action. Both parties filed motions for summary judgment limited to the question whether Mr. Klopfenstein was a prevailing party within the meaning of section 7430.

A taxpayer may recover costs under section 7430 by satisfying four requirements:

  1. The costs must be incurred in an administrative or court proceeding in connection with the determination, collection, or refund of tax, interest, or penalties;
  2. the taxpayer must exhaust all administrative remedies;
  3. the taxpayer must not unreasonably protract the proceedings; and
  4. the taxpayer must be the prevailing party.

(In addition, only taxpayers who satisfy certain net worth requirements qualify.) The term “prevailing party” is defined in section 7430(c)(4)(A) as the party who has substantially prevailed with respect to either the amount in controversy or the most significant issue or set of issues presented. Given the difference between the penalties asserted and those ultimately agreed upon in the settlement, the IRS agreed that Mr. Klopfenstein had substantially prevailed with respect to the amount in controversy.

Under section 7430(c)(4)(B), a party may not be considered the prevailing party if the government establishes that its position in the proceeding was substantially justified. Section 7430(c)(4)(B) defines the government’s position in an administrative proceeding as its position on the earlier of (i) the date on which the taxpayer received Appeals’ notice of decision or (ii) the date of the notice of deficiency. The court held in the government’s favor, explaining that a party can never be a prevailing party unless the IRS has taken a position that is “crystallized” into either one of those documents. As to the first, Mr. Klopfenstein’s case was settled at Appeals so no decision was issued. As to the second, taxpayers can never recover fees under this prong in proceedings involving assessed penalties, where a notice of deficiency is not issued. Consequently, Mr. Klopfenstein could not have been a prevailing party.

Mr. Klopfenstein’s losing argument was based on the structure of the statute. Section 7430(c)(4)(B) is an exception to the definition of prevailing party in section 7430(c)(4)(B). (Indeed, it is captioned as an exception.) Thus, if Mr. Klopfenstein substantially prevailed with respect to the amount in controversy (which the government conceded), he is the prevailing party unless the government establishes that its position was substantially justified. Logically, in Mr. Klopfenstein’s view, if the government never took a position (which the government also conceded), then Mr. Klopfenstein must be a prevailing party.

Mr. Klopfenstein’s argument is logical, reasonable and consistent with the statutory language. Indeed, a commonsense definition of “prevailing party” in the context of litigation likely would encompass a party whose adversary “lost” with respect to 90 percent of its claim. Thus, whether or not a denial of attorneys’ fees in cases such as this makes sense as a matter of policy, the viewpoint adopted by this court (based though it was on precedent) is awkward at best.

Had the government conceded that it took a position in the case, Mr. Klopfenstein might not have succeeded in recovering fees in any event. Under section 7430(c)(4)(B), attorneys’ fees are not awarded if the government establishes that its position was “substantially justified.” Substantial justification is a relatively low standard. It requires merely that the position have a reasonable basis in law and in fact. Treas. Reg. § 301.7430-5(d).

The best way to overcome the substantial justification hurdle is to make a qualified offer. Simply stated, if the IRS does not accept a taxpayer’s qualified offer to settle a case and the taxpayer receives a judgment that is equal to or less than the offer, the taxpayer is deemed to be the prevailing party; whether the government’s position was substantially justified or not is irrelevant. (The qualified offer rule is set forth in section 7430(c)(4)(E).) Unfortunately for Mr. Klopfenstein, however, the qualified offer rule applies only if a judgment is entered in a court proceeding. Because the case was settled before a court proceeding had commenced, the qualified offer rule did not apply.

Addendum: The Tax Court has jurisdiction to review IRS decisions whether to grant or deny (in whole or in part) requests for attorneys’ fees. Section 7430(f)(2); Tax Ct. R. 271. In docketed cases, the taxpayer must raise the claim during the case itself; res judicata precludes consideration of costs in a subsequent proceeding to the extent that the issue could have been pursued in the earlier case. Gustafson v. Commissioner, 97 T.C. 85 (1991); Foote v. Commissioner, T.C. Memo. 2013-276. Where the matter has been resolved administratively, the taxpayer must file a petition with the Tax Court within 90 days after the date on which the IRS mails a notice of decision. The taxpayer, not the attorney, is the proper party to file the claim. Greenberg v. Commissioner, 147 T.C. 382 (2016).

Pursuing Donees for Unpaid Gift Taxes

We welcome first time guest blogger Brian Krastev, a 3L at Syracuse University College of Law and a student of past guest blogger Professor Robert Nassau. Christine

United States v. Estate of Sidney Elson, No. 2:18-cv-11325 (D. N.J. 2019) addresses the statute of limitations on collection of gift taxes from donees. The case involves a father who failed to pay the gift taxes on substantial gifts he made to his children (I hope my father knows that I’d gladly handle his gift tax return if he’d like to send me substantial gifts). The children acknowledge that their father did not pay the gift taxes but argue, inter alia, that the statute of limitations in IRC 6324(b) prevents the IRS from pursuing collection against them. The district court finds that, so long as the statute of limitations on collecting from the father has not expired, the IRS can still seek to obtain the taxes from the children. Unpaid gift taxes bear many similar traits to unpaid estate taxes. In both cases, when the donor or executor is unable to pay the tax, the donees or heirs are personally liable to the extent of the value of the property they were gifted or bequeathed.

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Sidney Elson gifted two individuals each about $500,000 worth of property in 2004. He died in 2006 never having filed a return for either gift. Sheila Strauss, one of the two gift recipients and executrix of his estate, filed a gift tax return on behalf of the estate in 2009. This return included the gifts made in 2004, but it only reported $80,000 of tax liability. The IRS sent the estate a notice of assessment in 2011 for $375,000 in additional gift taxes. Despite the estate making payments toward the liability, the IRS alleged that as of December 4, 2017, $685,000 remained outstanding. The IRS brought a suit in 2018 to collect the taxes from, among others, the aforementioned two donees.

The two defendants filed a motion to dismiss which, although procedurally improper, the court decided to consider as a motion for judgment on the pleadings. The motion is based primarily on two issues: (1) That the IRS suit is untimely because the ten-year period of limitations on a gift tax lien under IRC 6324(b) had expired; and (2) that the IRS failed to individually assess them pursuant to IRC 6901, and any such assessment would now be untimely.

§ 6324(b) provides:

[Sentence 1] Unless the gift tax imposed by chapter 12 is sooner paid in full or becomes unenforceable by reason of lapse of time, such tax shall be a lien upon all gifts made during the period for which the return was filed, for 10 years from the date the gifts are made. [Sentence 2] If the tax is not paid when due, the donee of any gift shall be personally liable for such tax to the extent of the value of such gift. [Sentence 3] Any part of the property comprised in the gift transferred by the donee (or by a transferee of the donee) to a purchaser or holder of a security interest shall be divested of the lien imposed by this subsection and such lien, to the extent of the value of such gift, shall attach to all the property (including after-acquired property) of the donee (or the transferee) except any part transferred to a purchaser or holder of a security interest.

§ 6901(a) provides, in pertinent part:

[Donee gift tax and certain other] liabilities shall…be assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred.

Section 6901 goes on to provide a statute of limitations on assessment, which is generally “within 1 year after the expiration of the period of limitation for assessment against the transferor.” IRC 6901(c).

The district court interprets IRC 6324(b) in accordance with U.S. v. Botefuhr, 309 F.3d 1263 (10th Cir. 2002), a practically identical case, which analyzes the “personal liability provision” (sentence 2) separately from and without reference to the “lien provision” (sentence 1). In doing so, the court determines that the 10-year period of limitations in sentence 1 does not apply to the personal liability provision of sentence 2. Instead, IRC 6501 (generally 3 years to assess after a return is filed) and IRC 6502 (generally 10 years to collect after assessment) provide the appropriate statutes of limitation. The court finds that the gift tax assessment against the estate, and the filing of this action against the estate and donees, were timely under sections 6501 and 6502.

This court also finds that a personal assessment under IRC 6901 is not a prerequisite to bringing an action against the donees under IRC 6324(b). It reaches this conclusion following U.S. v. Geniviva, 16 F.3d 522 (3d Cir. 1994), which held that a section 6901 assessment was not mandatory before the government could bring an action under IRC 6324(a)(2) (the estate tax sister to 6324(b)). The court notes that section 6901 was enacted after section 6324, and finds that in the later section Congress merely provided an additional tool for the government to collect against transferees. The court entirely rejects the donees’ view of section 6901 as a limitation on section 6324.

This court concludes that the action is timely against the donees because the statute of limitations under IRC 6502 on collection from the donor had not expired when the suit was filed. Additionally, the IRS was not required to personally assess the donees under 6901 to pursue collection from them in a suit under section 6324. Therefore, this court holds that the collection action against the defendants is timely and procedurally proper.

Something about this decision rubs me the wrong way. It seems unfair that donees—potentially oblivious to a donor’s neglect to pay taxes—can be on the hook for a tax liability many years down the line, a tax liability which has likely amassed penalties and interest far in excess of that originally due.

Specifically, in this decision I find troubling the following three points:

1. Botefuhr’s separate analysis of personal liability

The Tenth Circuit justified distinguishing sentence 1 and sentence 2 of IRC 6324(b) by referencing several cases dealing with collection of unpaid gift taxes from donees. However, the statute of limitations on collection was not at issue in these cases. In fact, the actions against the donees were all brought within 10 years from the date of the gifts at issue, while the “sentence 1 lien” was in effect. It seems more likely that the reason these cases independently addressed the personal liability sentence of IRC 6324 is because the donees disputed their personal liability altogether. For example, the court cites to the following:

  • La Fortune v. C.I.R., 263 F.2d 186 (10th Cir. 1958).
    • Primary issue is valuation of gifts. Secondary issue is whether the IRS can collect unpaid gift tax from donees where donor is solvent and where the gift tax liability arose from gifts made to other donees during the year.
  • Mississippi Valley Trust Co. v. C.I.R., 147 F.2d 186 (8th Cir. 1945).
    • Issue is whether the IRS can collect unpaid gift tax from donees where donor is solvent, failed to report taxable gifts, and was not assessed.
  • Baur v. C.I.R., 145 F.2d 338 (3d Cir. 1944).
    • Issues are whether the IRS can collect unpaid gift tax from donees where the the tax liability arose from gifts made to other, the statute of limitations on collection from the donor has expired, and the donor is solvent.
  • Tilton v. C.I.R., 88 T.C. 590 WL 39956 (1987).
    • Issue is whether the IRS can collect unpaid gift tax from donees in general.

2. Botefuhr’s application of IRC 6501 and 6502 to donee personal liability

The Tenth Circuit refused to apply the 10-year statute of limitations on the gift tax lien of sentence 1 to the personal liability of sentence 2 by referencing cases which found that IRC 6502 established the statute of limitations for collection from donees. However, would the court have done the same for the lien transfer of sentence 3? Sentence 3 directly refers to the gift tax lien created by sentence 1 and transfers it to all the donee’s property if the gift is transferred out of the donee’s possession. I speculate that the 10-year statute of limitations would surely carryover to sentence 3. In that case, it makes less sense to isolate the personal liability of sentence 2 and apply the donor’s statutes of limitations of IRC 6501 and 6502.

3. Geniviva’s treatment of IRC 6901 as an additional collection method

The Third Circuit in Geniviva found that an individual assessment under IRC 6901 was not required to collect unpaid estate taxes from donees. This decision was based on Leighton v. U.S., 289. U.S. 506 (1933), a case which dealt with personal liability of unpaid estate taxes in the context of corporate distributions. Additionally, the Supreme Court in Leighton was interpreting section 280(a) of the Revenue Act of 1926—the precursor to IRC 6901. The Third Circuit could have probably distinguished the case for these reasons.

In discussing these reasons with my tax professor, Professor Robert Nassau, he made a very compelling counterpoint which I initially overlooked. He raised the argument that the gift taxes in these cases are rightfully owed and it would be unfair to expect the IRS to track down every relevant donee whenever a gift tax deficiency is alleged. To hold otherwise might incentivize donors to gift all their assets, never pay the tax, and ignore the IRS in hopes that the statute of limitations expires on collection from the donees.

Ultimately, I think a more equitable approach would be to treat IRC 6324 as the additional method of collection, apply the 10-year statute of limitations of that section to the personal liability it imposes, and mandate assessment under IRC 6901. This would provide donees with the same procedural safeguards on assessment and collection available to taxpayers in every other instance. The IRS would still have ample time to collect from donees under IRC 6901—the downside being they would have to assess them much sooner.

We need a permanent National Taxpayer Advocate, now.

Contributor Nina Olson returns with her thoughts on the importance of filling the vacancy at the head of the Taxpayer Advocate Service.

This week, the acting National Taxpayer Advocate released the 2019 Annual Report to Congress, on the heels of the IRS’s release of its own “annual report” about its performance. Reading the two documents together, one wonders whether they are reporting on the same agency. The NTA’s report focuses on the challenges the agency faces and makes concrete recommendations about how to address them; the IRS’s report celebrates the agency’s performance over the last year and how it is on track to fulfill the goals of its 2018 to 2022 strategic plan. One report is forward looking; the other is a status update.

I’ll be scouring the contents of both reports over the next month or so, but their arrival reminds me of the important and unique role the National Taxpayer Advocate (NTA) plays in U.S. tax administration today. The NTA is the protector of taxpayer rights and, according to the National Commission on Restructuring the IRS, serves as the “voice of the taxpayer” inside the agency. Each of the Most Serious Problems, Most Litigated Issues, and Legislative Recommendations in the NTA’s 2019 Annual Report to Congress is prefaced with the relevant rights enunciated in the Taxpayer Bill of Rights; they form the framework for analysis. On the other hand, the IRS annual report doesn’t get around to mentioning “taxpayer rights” until page 12. Tellingly, the words “taxpayer rights” do not appear in any of the strategic goals listed in the annual report, nor are they listed among the “core values” of the agency.

This contrast highlights why it is so important to have a permanent National Taxpayer Advocate in place, to hold the IRS’s feet to the fire about promotion and protection of taxpayer rights, especially as it hires more audit and collection employees and launches new compliance and enforcement initiatives. The NTA is the person at the table of the IRS senior leadership who is charged (by Congress) with reminding the IRS that its primary job is to promote voluntary compliance, that enforcement revenue only counts for about 2 percent of all revenue collected, that the vast majority of U.S. taxpayers are trying to comply with the mind-numbingly complex tax laws, and that personal assistance and education is a, if not the, most significant factor in enabling these taxpayers to meet their obligations.

That is why it is so disturbing that there is no permanent NTA appointed by the Secretary of the Treasury, a full nine months after I announced my retirement as the NTA. On March 1, 2019, I publicly informed Treasury, the IRS, and everyone else that I would be retiring on July 31, 2019. I announced my retirement that early, against the counsel of several of my closest advisors and friends who feared I might become a “lame duck,” because I believed it was important to have a successor named and ready to assume the duties immediately upon my retirement. I knew of several highly qualified people interested in the job, and indeed, the recruitment process identified several excellent candidates. At the time of my retirement, I knew of three excellent candidates who were on a very short list.

So what happened? Why is there no NTA? I have no clue. What I do know is that despite the excellent interim leadership of the Taxpayer Advocate Service, no acting NTA can do the job as Congress envisioned. Indeed, Bridget Roberts, the acting NTA, states in the 2019 Annual Report, “As in other organizations, acting leaders are caretakers — charged with keeping the trains running on time but lacking the authority to make significant changes and often not taken as seriously as permanent officials.”

Let’s take a step back and look at what Congress did in 1998 when it amended IRC 7803(c), the statute that lays out the requirements for and duties of the Office of the Taxpayer Advocate. Congress made changes to this statute after widespread dissatisfaction with the then-Taxpayer Advocate structure surfaced in the hearings before the National Commission on Restructuring the Internal Revenue Service. In the chapter titled “Taxpayer Rights,” the Commission outlined these concerns:

Currently, the national Taxpayer Advocate is not viewed as independent by many in Congress. This view is based in part on the placement of the Advocate within the IRS and the fact that only career employees have been chosen to fill the position. Because a candidate for the job is likely to have additional career ambitions at the IRS after performing the Advocate position, it is difficult to perceive the Advocate as independent when the position is regarded as just another assignment for an IRS executive, with the Commissioner viewing his or her performance as determining the next position. Additionally, while the Advocate has provided recommendations for improvements at the IRS, these recommendations merely tend to highlight ongoing IRS corrective efforts with little in the way of recommendations that focus attention on issues that the IRS either is doing nothing or its efforts are inadequate. Finally, what recommendations the Advocate has provided have limited value because they do not prescribe specific legislative or administrative corrections.

A Vision for a New IRS, Report of the National Commission on Restructuring the Internal Revenue Service, June 25, 1997, at 43.

Congress addressed these concerns in the Internal Revenue Service Restructuring and Reform Act of 1998. It sought to ensure the independence of the Advocate by radically transforming the Office of the Taxpayer Advocate into an independent organization within the IRS. IRC 7803(c) explicitly lays out the requirements for appointment of the NTA and the qualifications of the person who fills that position. (By the way, 7803(c) is longer than 7803(a) or (b) which govern the positions of Commissioner and Chief Counsel, respectively. 7803(a) was recently lengthened by the addition of 7803(a)(3), which requires the Commissioner to ensure that IRS employees “are familiar with and act in accord with taxpayer rights ….”)

  • First, the National Taxpayer Advocate “shall be appointed by the Secretary of the Treasury after consultation with Commissioner of Internal Revenue and the Oversight Board and without regard to the provisions of title 5, United States Code, relating to appointments in the competitive servicer or the Senior Executive Service.”
  • Second, the NTA cannot have worked for the IRS for 2 years immediately preceding the appointment or 5 years immediately after leaving the position (there is an exception for current employees of TAS).
  • Third, the NTA must have the following experience: “(I) a background in customer service as well as tax law; and (II) experience in representing individual taxpayers.” (7803(c)(1)(B)(iii))

Thus, according to the law, the Secretary can make this appointment without it being nominated by the President or confirmed by the Senate. The usual hiring processes for federal civil service or Senior Executive Service do not apply – the Secretary merely needs to make his or her decision, sign an appointment document, and that’s it. Obviously, there should be a background check, and ultimately a tax check and tax audit, but the appointment of the NTA is one of the least bureaucratic in the federal government. So bureaucratic hurdles are not an excuse for the delay in appointing the Advocate.

It is interesting to note that Congress sought to balance the voices that the Secretary listened to in making his or her appointment decision. Not only is that decision made in consultation with the Commissioner, but also the Oversight Board weighs in. When I was under consideration for the position in late 2000, I was interviewed by the Commissioner several times, and had a lengthy interview with a subpanel of the Oversight Board. The Commissioner produced a memo for the Secretary recommending my appointment, and the Oversight Board produced a 27-page report (if recollection serves) including observations about each of the candidates and ultimately recommending my appointment. Thus, the Secretary had ample information with which to make his decision.

Today, there is no functioning Oversight Board. The Secretary only has the consultation of the Commissioner. The Commissioner’s statutory duty is to “administer, manage, conduct, direct, and supervise the execution and application of the internal revenue laws…” One of the Oversight Board’s statutory responsibilities is “[t]o ensure the proper treatment of taxpayers by the employees of the Internal Revenue Service.” The Oversight Board brings this perspective to the selection process for the NTA. While the Commissioner may factor this in to his or her recommendation, the loss of the Oversight Board’s perspective means that the Secretary only has the IRS’s official perspective to rely on. The balance that RRA 98 brought to the selection process is missing.

Which brings me back to my original observation about the two reports released this week.

The NTA’s statutory duty is to assist taxpayers in resolving their problems with the IRS and to identify and make administrative and legislative recommendations to mitigate such problems. [7803(c)(2)(A)(i)-(iv)]. The National Taxpayer Advocate’s Annual Report to Congress is the key vehicle for fulfilling that duty. In the words of the Restructuring Commission, the NTA must “focus attention on issues that the IRS either is doing nothing or its efforts are inadequate.” In order to do this well, Congress has required that the NTA has experience in representing individual taxpayers. That is, the NTA must have sat across the table from the IRS and knows what it is like to be an individual taxpayer battling the IRS bureaucracy. The NTA must have experienced firsthand the pain of taxpayers. A successful NTA brings that knowledge and experience to every meeting with IRS officials and employees and never lets them forget it.

Today, no matter how articulate and talented TAS leadership is, that strong, independent, experienced voice, carrying with it the authority of the Secretary’s appointment, is missing as the IRS embarks on its enforcement “build” and drafts the numerous reports required by the Taxpayer First Act. This is something all of us who practice in and study the field of tax should care about.

We need a strong, qualified National Taxpayer Advocate. Now.

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 3)

We welcome back Megan Brackney for part three in her three-part series discussing penalties imposed on foreign information returns.  Today, she brings of stories of clients who have faced these penalties demonstrating the problems caused by the manner in which the penalties are being imposed and she brings suggestions of how to improve the system.  Keith

The Gifts That Keep on Giving

Two young people moved to the U.S. as students.  They met in graduate school and married.  After graduation, they were offered jobs and were sponsored by their employers so that they could stay in the U.S.  While they were students, their parents from their home country sent them money to help pay for their expenses in the U.S.  After they became U.S. taxpayers, they received a few more gifts, totaling more than $100,000.  They told their CPA about these gifts, and even showed him copies of their bank statements so that he could see the wire transfers from their parents’ non-U.S. accounts.  The CPA told them that because these were gifts and not subject to taxation, they did not need to be reported.  The CPA did not advise them of the Form 3520 filing requirement for gifts from foreign persons that exceed $100,000 in the aggregate during the tax year.  Neither of the taxpayers had any knowledge of the Form 3520, and genuinely believed that they were filing their returns correctly.

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A few years later, the taxpayers switched to a new CPA and again mentioned the gift issue, and she told them that they should have been filing Forms 3520 after they became U.S. taxpayers.  She prepared three Forms 3520 with statements explaining their reasonable cause, and the taxpayers filed them.  There was no audit or inquiry by the IRS and no tax due as a result of the error, and other than this understandable omission, they have a perfect compliance history.  The CPA was not aware of the Delinquent International Information Return Submission Procedures, but the taxpayers’ submission nevertheless substantially complied with the requirements for that procedure. 

Soon after their good faith attempt to self-correct, the IRS assessed the maximum amount of penalties on both taxpayers pursuant to I.R.C. § 6039F – 25% of the amount of the gifts they had received.  The IRS issued separate notices for the three years so that there were three different deadlines for the appeals, and thus three separate appeals.       

These notices were entitled “Notice of Penalty Charge.”  The Notices stated merely that “you have been charged a penalty under Section 6039F of the Internal Revenue Code for Failure to File Form 3520 to Report Receipt of Certain Gifts” and did not provide any other information or explanation.  As the word “charge” does not appear in the Code or Regulations, a lay person would not know from this notice whether there has actually been an assessment of the penalty. 

The only information provided about how to challenge the penalty was to state that the taxpayer could submit a written request for appeal within 30 days from the date of the notice which, “should reflect all facts that you contend are reasonable cause for not asserting this penalty.” 

The notice does not contain any information about collection while the appeal is pending but contains the following statement: “If you do not wish to appeal this penalty, there is nothing you need to do at this time.  You may later dispute the penalty by paying the penalty and then filing a claim.”  A reasonable layperson could interpret this to mean that the taxpayer does not have to pay the penalty until after his or her appeal.  And, indeed, as noted in the previous column, Internal Revenue Manual 8.11.5.1 states that taxpayers are afforded pre-payment appeals.  The notice does not explain any of this, however, and yet the IRS will only suspend collection activity if the taxpayer separately notifies Collections that he or she has filed an appeal (and frequently not even then).

Moreover, from the notice, there is no indication that the IRS obtained managerial approval of the penalty, as is required by I.R.C. § 6751(b), and no indication that the IRS considered the reasonable cause defense submitted along with the Forms 3520. 

The taxpayers timely submitted an appeal to each penalty, explaining again that they had reasonable cause for failure to file foreign information returns, i.e., that that they retained a competent CPA to prepare their returns, that they gave him full and complete information, and they reasonably relied on his advice that nothing needed to be done to report the gifts from their parents.

Despite the timely appeals, the IRS has continued sending collection notices.  In response to Notice CP504, the taxpayers requested that the IRS place a hold on collection pending the appeal.  The IRS did not respond, but moved forward with issuing the notice of intent to levy on one tax year.  The taxpayers were forced to file a CDP request to prevent enforced collection while Appeals considers their reasonable cause defense.  The taxpayers are frightened that the IRS will file a notice of federal tax lien, which would be devastating as they are trying to buy a house right now.  

In the meantime, for one of the tax years, the IRS sent the taxpayers a notice stating that it was rerouting the taxpayers’ correspondence (the timely filed appeal) to the Frivolous Correspondence Department.  The taxpayers promptly responded with a letter explaining that their appeal was not frivolous, and that they had a right to Appeals review, and that the IRS cannot refuse to forward their protest to Appeals.  They have received no further communications regarding the appeal. 

For another tax year, the taxpayers received a cryptic letter from the Service Center, responding to their correspondence (with the same date as the appeal for that year), by stating “We reviewed the information you provided and determined that no action is necessary on your account.”      

The taxpayers have not received any further communications from Appeals.  We have tried to find someone at the IRS who has this file, but have had no luck.  Although the Service Center told me that their case is assigned to the field, no one at that office has specific responsibility over it.  As of the date of publication of this column, the taxpayers have been waiting for over a year for an Appeals conference.  Meanwhile, the IRS collection machinery rolls on, without regard to the fact that the taxpayers have never had any Appeals review of the assessments. 

Welcome to the Machine

This taxpayer is a non-U.S. Person who is the sole shareholder of several U.S. real estate holding companies.  Due to some serious health issues, including dementia and loss of hearing, he fell behind on filing returns.  His son began taking over the business, discovered that returns had not been filed, and starting filing Forms 1120, which included Forms 5472, and a reasonable cause statement explaining his father’s health problems and his inability to file returns on time.  The entities filed the Forms 5472 for years which there was no tax due and owing pursuant to the Delinquent International Information Return Submission Procedures.  For the years in which tax was due, the entities filed the returns in the ordinary course but attached reasonable cause statements.

The IRS’s response to these various filings has been haphazard.  For many of the Forms 5472, no penalties were imposed at all.  There is no discernible pattern – sometimes tax was due, sometimes it was not; sometimes the year at issue was the first year of correction, sometimes it was a later year.  The taxpayers have no complaints about not getting penalties on these years, but it does make one wonder whether the IRS just failed to catch them, or if someone evaluated the reasonable cause defense and agreed that penalties would not be appropriate, and if this is the case, why penalties were imposed for other tax years with identical facts.

For the rest of the Forms 5472, the IRS sent out notices assessing penalties for $10,000 per form for each of late-filed Forms 5472.  The Tax Cuts and Jobs Act of 2017 (“TCJA”) increased this penalty to $25,000 for each late-filed or incomplete Form 5472.  On almost all of the notices, the tax year was mistakenly stated.  The entities are fiscal year taxpayers, with their tax years ending on different dates, such as June 30, or September 31.  The U.S. companies’ fiscal year, was, of course, stated on the front of the Forms 1120, and thus that information was available to the IRS.  However, the IRS identified the penalty period for all years as ending on December 31.

In any event, the notices of penalty were on a different form than those issued to the taxpayers described above.  These notices had a heading stating, “We Charged You A Penalty.”  This notice provided thirty days to notify the IRS if “you don’t agree with the penalty assessment,” and provided instructions on presenting a reasonable cause statement under penalties of perjury.  The notice does not explain whether this submission would be an appeal or a request for abatement.  Like the notice to the other taxpayers, this notice does not provide any information about collection or indicate whether managerial approval has been obtained or acknowledge that the taxpayer had already submitted a statement of reasonable cause under penalty of perjury.  And again, there is no concept of a “charge” under the Internal Revenue Code, and it would not be clear to a lay person trying to interpret this notice what this meant. 

In response to these notices, the entities requested abatement of penalties on the ground of reasonable cause, and the IRS granted several of these requests, with no explanation.  It is possible that for some of these penalties, the IRS was applying a concept of First Time Abatement, since they were the first tax years with non-compliance.  The First Time Abatement provisions of the Internal Revenue Manual do not refer to foreign information return penalties, but I suspect that this relief may have been granted for these entities, and I have heard, anecdotally, from other practitioners, that their clients have received this relief. 

For the penalties on which the IRS denied the request for abatement, the IRS provided an explanation for the denial and obtained proper managerial approval under I.R.C. § 6751(b).  In the letter denying the abatements, the IRS stated that the taxpayer could appeal the decision.  It is unclear why these taxpayers were provided with a two-step procedure – request abatement, and then appeal of the denial of the abatement request — while the taxpayers described above were told to go directly to Appeals.  In any event, the IRS provided these entities with 60 days in which to submit an appeal, and the entities have done so, but several months later, they still have not heard from Appeals.

In the meantime, on all of the remaining penalties, the IRS has sent collection notices, and each time, the entity responded with a request a hold on collection pending its appeal.  The IRS did not directly respond to any of this correspondence, but for some of the entities, the IRS seems to have stopped sending notices.  For other entities, the IRS issued final notices of intent to levy.  Despite already having one appeal pending, these entities were forced to submit CDP requests to avoid levy. 

In addition, for several of the penalty assessments, the IRS filed notices of federal tax lien.  As noted, the Code section that authorizes the penalty for failure to file the Form 5472 is I.R.C. § 6038A.  However, on several of the notices, the IRS stated that the penalty had been assessed under I.R.C. § 6038.  This is close, but not quite right – this is the penalty for failure to file Form 5471.  On one of the notices of federal tax lien, the IRS did not even get close, but identified the penalty as being assessed pursuant to I.R.C. § 6721 (trust fund recovery penalties).  And, as noted above, the IRS assessed the penalties for tax years ending December 31, even though the entities’ tax years do not end on December 31, but at the close of their fiscal year.  As these notices were improper and inaccurate, and the taxpayer’s Appeals had not been heard, the entities had to file CDP requests challenging the federal tax lien filings. 

The entities have not received any response to their appeals, many of which have been pending for more than a year.

Perfection is the Enemy of Good

The next taxpayer is a high net worth individual who is the grantor of a foreign trust with significant assets.  Since the formation of the trust, he has always timely filed Forms 3520 and Forms 3520-A and reported all income related to the trust.  At some point, the country codes stating where the trust was administered and what law applied were not included on the Form 3520, although that information is included in other parts of the form.  The IRS caught this error on the Form 3520 for one year and assessed a multimillion-dollar penalty pursuant to I.R.C. § 6677.  There was no tax non-compliance related to this error – it was a minor and inconsequential technical error on a timely filed return.  The taxpayer did not notice this minor error during his review of his returns and he certainly did not instruct his CPA not to fill out these items on the form.  Other than this minor foot-fault, the taxpayer has an excellent compliance history.

The notice was entitled “Notice of Penalty” charge, and provided for 30 days to appeal or request abatement and directed the taxpayer to correct the errors within 90 days or be subjected to additional penalties.  The language of the notice was unclear as to whether the taxpayer would be able to appeal if the request for abatement was denied.  To be on the safe side, the taxpayer submitted an appeal to the IRS explaining that the taxpayer had reasonable cause for the error based on reliance on his CPA, and that penalties were not appropriate because he substantially complied with the Form 3520 filing requirement. 

There is no indication from the notice that the IRS obtained managerial approval under I.R.C. § 6751, and the notice did not provide any information about suspending collection.  Before the 30-day deadline for the appeal, the IRS sent Notice CP504, taking the first steps toward enforced collection action, despite the fact that the taxpayer’s time to appeal had not yet elapsed.  The Appeal is pending, unless the IRS changes its practices, despite the timely appeal, which should be successful, the taxpayer may have a federal tax lien filed against him and may receive a notice of intent to levy and be forced to submit a second appeal through CDP.    

Suggestions for Improving Penalty Enforcement Procedures

Below are a few simple suggestions for the IRS that would go a long way toward fair and efficient administration of the Internal Revenue Code penalty provisions.

1.          Stop systematically assessing these penalties.  These are significant penalties and it is important that they only be assessed in appropriate cases.   

2.         Consider that a taxpayer voluntarily self-corrected.  Instead of encouraging voluntary compliance, the IRS is severely penalizing taxpayers without any proper purpose.  The message that the IRS is sending to taxpayers is not to attempt to resolve issues voluntarily and self-correct, as the IRS treats taxpayers who come forward to correct past non-compliance in the same manner – as harshly as possible – as those whom the IRS identifies as non-compliant. 

3.         Apply concepts of substantial compliance.  Missing a line on a form should not warrant the highest level of penalty assessment where there is no tax due or other harm to the government.

4.         Formally adopt a First Time Abatement policy for foreign information return penalties that is applied consistently among taxpayers. 

5.         Find a way to follow the Internal Revenue Manual.  Wait until the time has elapsed for filing an appeal before commencing collection action, and upon receipt of the appeal, immediately stop collection.  If there is no system in place to cause this to happen automatically, create one, or, at a minimum, add a line to the notice telling the taxpayer that if they receive a collection notice, they should notify the office that sent the notice that they have timely filed an appeal of the penalty.  Then, instruct Collections to suspend collection activity once they receive notification that an appeal has been filed.

6.         Train IRS personnel in the Service Center and Collection about these penalties, so that they know what they are and how the procedures are different than those that may apply to the usual situations they see with taxpayers who have income tax liabilities so that they are able to respond to taxpayers who call for assistance. 

7.         Use consistent language in the penalty notices.  There is no reason for there to be different versions of the notices that taxpayers receive when foreign information penalties are assessed. 

8.         Use language that tracks the statute.  There is no such thing as a penalty “charge” in the Internal Revenue Code or Treasury Regulations.  It is an assessment, and it is misleading to call it something else.

9.         Clearly describe how the taxpayers may submit their reasonable cause defenses to the IRS, and state that if the IRS denies abatement, they may request an appeal.

10.       Notify taxpayers that they can request additional time to appeal and explain the process for doing so, or provide a longer time period and make it consistent for all taxpayers. 

At this point, there have been very few court decisions addressing reasonable cause and other defenses to foreign information return penalties, and none addressing the IRS’s procedures.  This may be because the increase in systematic assessments is fairly recent, and it also may be because for Forms 5471, 8938, and Forms 5472 (until the TCJA increased it), the penalty of $10,000 per form did not warrant the cost of federal litigation.  The IRS should not take advantage of the fact that most people will not go to court to challenge these penalties, but should take immediate action to ensure that they are being applied in an appropriate manner, and that taxpayer’s right to challenge the IRS’s position and be heard, the right to appeal an IRS decision in an independent forum, and the right to a fair and just tax system are being honored and protected.  As can be seen by the cases discussed in today’s post, the IRS is not taking steps to protect these rights. 

Breaking Rule 36: When IRS Fails To Answer a Petition

Bob Kamman returns with a tale of woe that will hopefully be short-lived. I trust the matter will be resolved promptly once Bob is able to communicate with the Chief Counsel attorney assigned to the case. The situation shows the importance of the Answer telling the petitioner or representative who they can call to resolve their case. Too frequently it seems that IRS correspondence exam jumps the gun and issues an unnecessary notice of deficiency. Like Bob, my practice is to file a petition in these cases without waiting the full 90 days. I have not had any luck asking the IRS to rescind a notice of deficiency under section 6212(d) on the basis that exams reviewed and accepted my client’s substantiation after issuing the SNOD, so I may as well get the petition done early. A streamlined rescission process for cases like these would avoid unnecessary petitions filed by us cautious and pessimistic lawyers. Christine

I’m the Rodney Dangerfield of tax practitioners.  I get no respect.  At least from IRS, in Tax Court.

Other lawyers who blog or comment here: They file a Tax Court petition, IRS files an answer.  When I file a petition? It’s ignored. 

See Docket No. 19789-19.  Filed November 1, served on IRS November 6. Tax Court Rule 36 grants IRS a generous 60 days to file an answer.  That time expired January 6 (because January 5 was a Sunday). 

Compare that to  Docket No. 19787-19P , filed a few days after my case  and served the same day as mine.  The petitioner there is represented by Keith Fogg, who gets respect.  IRS filed an answer in that case on December 20, even though they had to send it to Kentucky for a lawyer who handles passport cases. 

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You might notice that I requested Washington, D.C., as the place of trial.   I thought that would expedite settlement.  Maybe IRS has less respect for practitioners who seem to be forum shopping.   I knew there was no way this case would go to trial, because it would be easy to settle once I could talk to a real person.  The disputed tax with interest  involves about $2,000, enough that a 3% filing fee was not out of line. 

It’s not like an IRS answer reflects more than a cursory look at the petition.  Most answers consist of a couple pages denying everything for lack of sufficient knowledge or information, up to but usually not including that the sun sets in the west.  But at least they provide the name of the attorney assigned to the case.

The lack of respect, however,  did not begin with IRS ignoring my Tax Court petition.  Its notice of deficiency was issued because my response to an IRS notice was ignored.   I had explained the mistake  on Schedule D was due to some missing Form 1099-B stock sales.

IRS sent its infamous CP-2000 on July 22, 2019, proposing a tax increase of $4,761.  (Being less than $5,000,  it was not quite enough to slap on the computer-generated Section 6662 penalty of another 20%.)

My letter to IRS on August 6 provided correct information.  It included copies of the relevant Forms 1099-B; and a 1040 (marked “Information Only, Do Not File”) showing the tax computation and a balance due of $2,847.  

On September 20, IRS mailed my clients a notice acknowledging they received my letter on August 12 and informing them that it would need another 60 days to respond.  But perhaps not coincidentally, the federal government fiscal year was ending soon.  Did Ogden Service Center managers exert  pressure to close cases so  year-end statistics would shine?  Not that they would admit.

Whatever the reason, a notice of deficiency dated October 15 was issued, showing the same adjustments as those on the original CP-2000.  It completely ignored the explanation I gave two months earlier.  Obviously, I get no respect. 

Hoping to move this case closer to settlement before the busiest days of the 2020 tax season, I filed the Tax Court petition a couple weeks later.  At some other time, in some other case, I would just wait and see how long it would take for IRS or the Tax Court to discover I had fallen through the cracks.  But my clients want to be done with the matter, and have already made an advance payment (Code Section 6603, Rev. Proc. 2005-18) of what they actually owe. 

(No, they are not paying me a fee, other than what I have received from them and their family in the last three decades as clients.   I could try to pursue IRS for fees, but life is too short for such bureaucratic ordeals.)

And filing the petition did get us some attention from IRS.  On November 18 – two weeks after Chief Counsel received the petition – IRS in Ogden mailed a revised CP-2000 proposing tax of only $3,057.  The $210 difference from our figures was due to keeping the tuition tax credit instead of changing it to a deduction, which saved money at the higher AGI.

The November 18 notice tells us, toward the bottom of Page 6, that “to recalculate your tax, we used . . .the new information you provided.”

Respectfully, may I ask anyone in charge at IRS (if that label is not an oxymoron): Why do you issue a notice of deficiency first, then look at the information provided?  Would it not be more efficient to do it the other way around?

The word “respect” does not appear in the part of the Taxpayer Bill of Rights (as explained in Publication 1) under “The Right To Quality Service.” It does promise, “Taxpayers have the right to receive prompt, courteous, and professional assistance in their dealings with the IRS.”

Oddly enough, “respect” appears later, in this context:

Taxpayers have the right to expect that any IRS inquiry, examination, or enforcement action will comply with the law and be no more intrusive than necessary, and will respect all due process rights, including search and seizure protections, and will provide, where applicable, a collection due process hearing.

The heading for that paragraph is “Right To Privacy.”  Tax Court proceedings offer little privacy.  Well, there is that thing about redacting SSN’s. 

I did some research on Tax Court procedures when IRS files a late answer.  The issue does not appear often, if at all.  I think it is safe to say: File a petition late, and the Court will dismiss the case for  jurisdictional reasons.  File an answer late, and the Court will excuse IRS on equitable grounds. 

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 2)

We welcome back Megan Brackney for part two in her three-part series discussing penalties imposed on foreign information returns.  Keith

Reasonable Cause

For all of the foreign information return penalties, reasonable cause is a defense.  See I.R.C. §§ 6038, 6038A(d)(3), 6038D(g), 6039F(c)(2), 6677(d); Treas. Reg. § 1.6038-2(k)(3)(ii).   The IRS applies the same standards for reasonable cause for failure to file income tax returns under I.R.C. § 6651 to failure to file foreign information returns, i.e., the exercise of ordinary business care and prudence.   See e.g., Chief Counsel Advisory 200748006

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In determining whether taxpayers satisfy the reasonable cause standard, the IRS also applies the holding of United States v. Estate of Boyle, 469 U.S. 241 (1985), to the failure to file foreign information returns.  Boyle articulates a non-delegable duty to file tax returns.  In that case, the executor of an estate relied on a tax advisor to file the estate tax return, but the advisor missed the deadline.  The Supreme Court explained that determining the due date and ensuring that the return was filed did not require any special tax expertise, and that taxpayers have a non-delegable duty to make sure that their returns are timely filed.  Any other rule, according to the Supreme Court, would not be administrable.  Id. at 249.       

However, the Supreme Court specifically contemplated that a taxpayer can rely on a tax professional’s advice as to whether to file a particular return.  As stated by the Supreme Court, “Courts have frequently held that ‘reasonable cause’ is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney that it was unnecessary to file a return, even when such advice turned out to have been mistaken.”  Id. at 250.  Other courts have reached similar conclusions.  See e.g., Estate of Liftin v. United States, 101 Fed. Cl. 604, 608 (2011) (an expert’s advice concerning a substantive question of tax law as to whether a return was required to be filed was reasonable cause).  Accordingly, a taxpayer should be able to rely on the advice of a tax professional as to whether a foreign information return is required (as opposed to merely meeting a known deadline). 

 Challenging Foreign Information Return Penalties

Foreign information return penalties are “assessable penalties,” meaning that they are “paid upon notice and demand” and are not subject to the deficiency procedures, and thus cannot be challenged in Tax Court (with one narrow exception discussed below).  I.R.C. § 6671(a). 

The Internal Manual states that the taxpayer is entitled to post-assessment, but pre- payment, Appeals review of the penalty.  See Internal Revenue Manual 8.11.5.1.  As we will see, the IRS does not automatically suspend collection activity in order to provide taxpayers with this pre-payment right to appeal, and routinely fails to respond to taxpayers’ requests to suspend collection during their appeals.  I have recently learned that the IRS’s failure to suspend collection may be due to an error in inputting the right code.  In one case, the Service Center told me that the collection hold had mistakenly been put on the 1040 account, rather than the civil penalty account.  I do not know how often this occurs, but it is concerning that a taxpayer could be subject to levy because of this type of an error.   

In any event, as we will see below, the notice of the right to appeal is cryptic, provides a short time to submit the appeal, and does not provide the taxpayer with information on whether or how to extend this deadline if the taxpayer needs more time.  

If the appeal is unsuccessful, the taxpayer’s only option for judicial review is to pay the penalty in full and file a refund claim, and if the refund claim is not granted (or acted upon within six months of receipt by the IRS), the taxpayer could then file a refund action in federal district court or the court of claims.  See I.R.C. § 7422; 28 U.S.C. § 1346(a)(1).

If the IRS does not offer Appeals rights before issuing a final notice of intent to levy, the taxpayer can file a CDP request with IRS Appeals, and at that point, should be able to raise defenses to the penalties, such as he or she acted with reasonable cause.  I.R.C. § 6330(c)(2)(B); Treas. Reg. § 601.103(c)(1); Interior Glass Systems, Inc. v. United States, 927 F.3d 1081, 1087 (9th Cir. 2019).  If Appeals does not grant relief during the CDP hearing, the taxpayer could file a Petition for Lien or Levy Action Under I.R.C. § 6330(d), in the United States Tax Court. 

Procedures to Get Into Compliance

The IRS has established the Delinquent International Information Return Submission Procedures, which may be helpful for some taxpayers in avoiding penalties, but there is no guarantee.  A taxpayer is eligible to use these procedures if he or she has reasonable cause for not timely filing the information returns, is not under a civil examination or a criminal investigation by the IRS, and has not already been contacted by the IRS about the delinquent information returns.  Under this procedure, the taxpayer sends in the delinquent return as directed by the IRS, along with a statement of facts establishing reasonable cause for the failure to file.

The IRS makes no express promises on the outcome under these procedures, but it is generally understood by tax practitioners that the IRS will not assess penalties if there is no tax liability related to the failure to file and the taxpayer has reasonable cause.  Nevertheless, we have seen the IRS assess penalties against taxpayers who have submitted their foreign information returns under these procedures, but as the IRS provides no acknowledgement that the taxpayer attempted to use the procedure, it is unclear if this is due to mistakes in processing or is intentional. 

The Delinquent International Information Return Submission Procedures are not difficult to locate if you already know to look for them.  However, there is no reference to these procedures or links to them on the other pages of the IRS’s website that discuss the foreign information return penalties themselves.  The average layperson, and even many tax practitioners, are not aware of the procedures.  On several occasions, clients have come to us after they have received notices of penalty assessments for late filing of Form 5471 or 3520, when no tax was due and they had a reasonable cause defense to late-filing, because their CPA’s filed the forms without a reasonable cause statement in the form required by the Delinquent International Information Return Submission Procedures. 

For individuals who made non-willful errors in their foreign information reporting, the Streamlined Voluntary Filing Compliance Procedures, may provide some relief.  Also, for taxpayers who acted willfully, or are concerned that that the IRS will view their non-compliance as willful, the IRS’s voluntary disclosure practice may be an option.

Even though these procedures are available to allow certain taxpayers to limit their penalty exposure, they are not a substitute for the IRS applying the penalty provisions as required by the Internal Revenue Code and following its own administrative procedures. 

Part III will explore some examples of foreign information return horror stories.  Unlike other genres of horror, these stories do not derive from rare events, but represent the day to day conduct of the IRS in this area. These are not isolated examples, and I could have described numerous other cases of my own clients, and on an almost daily basis, I hear similar stories from other attorneys and CPA’s who are seeing the systematic assessment of significant and, sometimes life altering, penalties against taxpayers for negligible errors and delinquencies. 

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 1)

We welcome guest blogger Megan L. Brackney who is a partner at Kostelanetz & Fink, LLP in New York City, and focuses her practice in civil and criminal tax controversies. Over the past couple of years, she and her colleagues have seen a significant influx in foreign information reporting penalties and have represented hundreds of taxpayers against the IRS on these issues.  She provides us with the wisdom gained from her experience.  Megan and I serve together as vice chairs of the ABA Tax Section.  I can tell from the experience of working with her what a great lawyer and counselor she is.  Keith

The IRS has been assessing more and more foreign information return penalties on taxpayers.  It is difficult to find statistics on this point, as the IRS’s reports on tax penalties lump all “nonreturn” penalties into one category, which includes failure to file Forms 1099, 8300, and other information returns, along with foreign information return penalties.  Even without the statistics, tax controversy practitioners know this to be true, as we have clients coming in with these assessments every day.  Many of these penalties are being systematically assessed, meaning that a penalty is automatically issued whenever there is a late-filed form or a form is missing information, without regard to the individual circumstances of the taxpayer.  In many cases, the penalties are wildly disproportionate to the taxpayer’s mistake, and serve no purpose other than to discourage taxpayers from voluntary compliance.

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The increase in penalty assessments has also increased the workload of IRS Appeals and there are significant delays in resolution.  As will be discussed below, while these appeals languish without any response or action, the IRS continues to move forward with enforced collection.  This is a waste of the taxpayer’s resources to be constantly receiving notices and attempting to call and correspond with the IRS, and sometimes filing multiple appeals because they have to resort to Collection Due Process (“CDP”) to stop the IRS from levying on their assets before their appeals are heard.  This is also a waste of resources for the IRS, and further burdens Appeals, as more CDP requests come in on cases that are already assigned to Appeals. 

The IRS has caused this chaos from overreacting to taxpayers who have filed late or incomplete foreign information returns while at the same time, not allocating additional resources to Appeals to deal with the additional volume, or instructing Collections and Service Center personnel as to how to handle these cases.  There are some very simple administrative fixes to these issues, which I will recommend at the end of this column. 

To provide some context, and hopefully to bring some order to the chaos, this column tells the stories of three taxpayers who have faced assessment of devastating foreign information return penalties and have been unable to get the IRS to consider their defenses, followed by ten recommendations for improvement. 

Background on Foreign Information Return Penalties

Before talking about these three illustrative cases, below is some basic information about foreign information return penalties.

 Types and Amounts of Penalties

Foreign information return penalties include penalties for failure to file:

  • Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations)
  • Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business)
  • Form 8938 (Statement of Specified Foreign Financial Assets)
  • Form 8858 (Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs))
  • Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships)
  • Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts)
  • Form 3520-A (Annual Information Return of Foreign Trust with U.S. Owner), and other forms.  (Note that Penalties for failure to file FinCen Form 114 (the “FBAR”) are not assessed under Title 26 (the Internal Revenue Code), but Title 31 (the Bank Secrecy Act).  See 31 U.S.C. § 5321.  The rules for assessment and collection of FBAR penalties are contained in 31 U.S.C. § 5321.  This column focuses only on the Title 26 foreign information return penalties and does not address the IRS’s enforcement of FBAR penalties.)    
  • See I.R.C. §§ 6038(c)(4)(B), 6038A, 6038B, 6038D(d), 6039F(c), 6677.  These penalties are related to the failure to file, or the incomplete filing, of these foreign information returns, and are not related to any tax deficiency.  Accordingly, the IRS can – and frequently does – assess these penalties even where there is no tax due as a result of the failure to file or the incomplete form.  

The penalties for not filing Forms 5471, 8938, 8858, and 8865 (to report ownership in a foreign partnership) are $10,000 for the initial failure to file the form, and an additional $10,000 for every 30-day period, or part thereof, after the IRS has notified the taxpayer of the failure to file, up to a maximum of $50,000, meaning that the IRS can assess penalties of up to $60,000 for each form.

Beginning with the 2018 tax years, the penalty for failure to file Forms 5472 have been increased to $25,000 per failure, an additional $25,000 with every 30-day period, or part thereof, after the IRS has mailed a notice of failure, with no outer limits.   

The penalty for failure to report a transfer to a foreign corporation on Form 926, or failure to report a transfer to a foreign partnership on Form 8865, is 10% of the fair market value of the transferred property, up to $100,000.

 The penalties for failure to file Form 3520-A to report a gift from a foreign person or inheritance from a foreign estate is 5% of the amount of such foreign gift/inheritance for each month for which the failure to report continues up to 25% of the foreign gift/inheritance.

 The penalty for not reporting a transaction with a foreign trust on Form 3520 is 35% of the “gross reportable amount,” increasing by $10,000 for every thirty days for which the failure to report continues up to the “gross reportable amount.”  The “gross reportable amount” is the transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, or the aggregate amount of the distributions so received from such trust during such taxable year.  I.R.C. § 6677(c).

 As with all penalties, the IRS is supposed to obtain proper managerial approval before assessment. I.R.C. § 6751(a)(2) (“no penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”)