The IRS’s Aggressive Enforcement of Foreign Information Return Penalties Has Created Ethical Dilemmas For Practitioners (Part 2)

December 8, 2022 by 6 Comments

In today’s post, Megan L. Brackney.turns to the challenging issues that practitioners must confront when faced with a client or potential client’s failure to file foreign information returns. Les

Ethical Standards Related to a Client’s Non-Compliance With Foreign Information Reporting

In yesterday’s post, I discussed some common penalties for failing to file foreign information returns and the practical and legal challenges associated with establishing that a client is entitled to relief from those penalties. Today we focus on how this penalty regime raises difficult ethical issues for practitioners who want to zealously represent their clients but also want to practice in a way that is consistent with their responsibilities and duties.

Circular 230 governs attorneys, CPA’s, enrolled agents, and others who practice before the IRS. On the subject of a taxpayer’s error or omission, Circular 230, Section 10.21 states as follows:

A practitioner who . . . knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return . . . must advise the client promptly of the fact of such noncompliance, error, or omission.” 

This section goes on to say that “the practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.”   It does not, however, require the practitioner to advise the client to self-correct. 

The Statements on Standards for Tax Services (“SSTS”),SSTS No. 6 contains a slightly different iteration of the duties concerning knowledge of a client’s error or omission:

A member should inform the taxpayer promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer’s failure to file a required return.  A member also should advise the taxpayer of the potential consequences of the error and recommend the corrective measures to be taken.

In SSTS No. 6(13) (Explanation).  the AICPA explains, however, that the SSTS do not require CPAs to advise clients to amend if “an error has no more than an insignificant effect on the taxpayer’s tax liability,” a question which  “is left to the professional judgment of the member based on all the facts and circumstances known to the member.”

On the taxpayer’s side, it is generally understood that taxpayers do not have an obligation to file amended returns. As stated in Badaracco v. Comm’r, 464 U.S. 386, 393 (1984), “[t]he Internal Revenue Code does not explicitly provide either for a taxpayer’s filing, or for the Commissioner’s acceptance, of an amended return; instead, an amended return is a creature of administrative origin and grace.”)

It is also generally understood that a tax practitioner cannot advise a client not to file a return that is currently due.  There is no guidance on whether the same is true for a delinquent return once the filing deadline has passed.  Do tax practitioners have an unending obligation to recommend that their clients file delinquent returns? 

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The IRS’s policy is to solicit unfiled income tax returns for the prior six years. See IRS Policy Statement 5-133, Delinquent returns—enforcement of filing requirements (IRM 1.2.1.6.18 (08-04-2006) ( “Normally, application of the above criteria will result in enforcement of delinquency procedures for not more than six (6) years. Enforcement beyond such period will not be undertaken without prior managerial approval.”). This indicates that there may be some period of time after which we would not view a practitioner’s advice not to file a tax return as unethical but this is by no means a clear standard (Last season’s Form 1040? Ten years ago?). 

Another aspect of the practitioner’s ethical duties is the prohibition on basing advice on the likelihood of audit.  For purposes of advising a client on a return position, it is clear that the tax practitioner cannot consider the likelihood of audit but must instead determine whether the position is objectively reasonable.I.R.C. § 6694(a)(2); Circular 230 10.34; SSTS No. 1(4), (5).   Circular 230, Section 10.37(a)(2) states that “the Practitioner must not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.”See also Regulations Governing Practice Before the Internal Revenue Service, 79 FR 33685-01 (“Treasury and the IRS agree that audit risk should not be considered by practitioners in the course of advising a client on a Federal tax matter, regardless of the form in which the advice is given.” ).

Does this rule apply when advising on whether to correct a past failure to file? 

What Advice Can We Give? 

fter considering the above ethical standards, if we return to the example of the college student, we know it is highly likely that if she files the Form 3520, the IRS will impose the maximum penalty.  If she does not self-correct, given the low audit rates and the fact that her non-compliance was several years ago, there is a very strong chance that the IRS will never audit this tax year.  Are we doing this client a disservice by not providing her with this information when as she decides whether or not to file the Form 3520 now?  Do the ethical standards for tax practitioners actually require me to lead my client into financial ruin in order to correct a five-year old mistake that caused no actual harm? 

It is not clear how the ethical rules apply in this context.  Is a taxpayer who previously filed an income return but failed to file a foreign information return more like a taxpayer filing an amended return or filing a delinquent return?   Certain foreign information returns, like Forms 5471 and 8938, are attached to the income tax return. And, the IRS has instructed that when taxpayers file these returns late, they be accompanied with a Form 1040X, even if there are no changes to the income tax return.   

One could argue that a practitioner does not have an ethical duty to advise clients to file delinquent Forms 5471 and 8938 and other foreign information returns filed with the income tax returns because that would be the equivalent of filing an amended return. 

But what about Form 3520?  As the instructions provide, Form 3520 is not filed with the income tax return, but separately filed with the IRS Service Center in Ogden, Utah. Is filing a Form 3520 more like filing a delinquent income tax return?

I have difficult time believing that there should be different ethical rules for forms attached to the income tax return, such as Form 8938, and a free-standing form like the Form 3520.  That is slicing it a bit too thin.  And many practitioners would say that for a delinquent return, after the filing deadline has passed, the situation is similar to that of an amended return, and they are not obligated to recommend that the client self-correct.  I think that this is a reasonable interpretation of the ethical rules, and that the Circular 230 practitioner is not required to recommend self-correction but should fully advise the client on the potential penalties, and the CPA should recommend self-correction if the failure to file a particular foreign information return is material.

What about the likelihood that a taxpayer will be audited in the future, after the non-compliance has already occurred?  Is it unethical for a practitioner to advise the client in our example ho failed to file the Form 3520 five years ago that there is almost no chance that the IRS will audit this issue?  The statute of limitations for assessment does not close until the taxpayer files all required foreign information returns.  I.R.C. § 6501(c)(8).  The same is true for income tax returns, for which the statute of limitations does not begin to run until the return is filed, but nonetheless the standard advice for long-term non-filers is to just file returns for the preceding six years.              

As to discussing the likelihood of audits, this information is publicly available,and we should be able to discuss it if a client asks.  However, I would still not base my advice on the likelihood of audit, as even with the currently low rates, I cannot accurately predict whether a particular client will be audited.  However, we can advise our clients on the potential outcomes if they are audited so that they can weight the cost of voluntarily compliance versus waiting to be contacted by the IRS. 

I believe practitioners should be able to use their professional judgment to advise clients while still upholding their ethical obligations to the IRS and the tax system.  On the other side, the IRS should re-think its enforcement of these penalties in order to encourage, rather than punish, voluntary compliance, and, as the IRM provides, live up to its own obligations to ensure that penalties “encourage noncompliant taxpayers to comply,” and are “objectively proportioned to the offense.” I genuinely want to encourage tax compliance, but it is challenging when it is so harshly penalized.  The IRS could help tax practitioners, as well as taxpayers, by providing some reasonable options for correcting past failures to file foreign information returns.

Filed Under: Circular 230, Civil Penalties Tagged With:

The IRS’s Aggressive Enforcement Of Foreign Information Return Penalties Has Created Ethical Dilemmas For Practitioners (Part 1)

December 7, 2022 by 2 Comments

Today’s guest post is the first of a two-part series by Megan L. Brackney. These posts raise important questions about practitioners’ ethical responsibilities when confronting clients’ potential exposure to penalties for failing to file foreign information returns. Megan previously wrote a terrific series of posts considering problems with the IRS’s administration of these penalties, and in today and tomorrow’s posts Megan situates how these problems raise challenges for practitioners wanting to effectively and ethically represent their clients.

Megan is a partner at Kostelanetz LLP in New York who focuses her practice in civil and criminal tax controversies. She would like to thank Grace Hall for her assistance in researching this series.  Grace was a paralegal in the D.C. office of the firm and is now attending the University of Virginia Law School. Les

The IRS’s practice of assessing penalties against taxpayers who voluntarily attempt to get into compliance with their filing of foreign information returns puts tax practitioners in a difficult position.  Most practitioners understand that they have an obligation to the tax system and genuinely strive to comply with that obligation to assist their clients with compliance. And, indeed, most taxpayers believe in tax compliance.  See Comprehensive Taxpayer Attitude Survey, 2017 Executive Report, Practitioners also have duties to their clients to ensure that they are not recommending actions that will cause them to unnecessarily incur penalties.  In the past several years, as the IRS continues to impose the maximum level of penalties against taxpayers who file untimely or incomplete foreign information returns, it is getting harder for practitioners to recommend that clients should self-correct, as the outcome is the same if they do not self-correct and are later audited.  

Most of us would agree, for instance, that a young person who received a reportable (but nontaxable) gift from a foreign relative for the first time and who prepared her own return and did not know about the Form 3520 requirement at the time of filing, but then filed it 6 months after learning about the filing requirement should not have to pay a penalty of 25% of the foreign gift to the IRS.  The IRS, however, would assess this penalty without a second thought – and indeed does so with regularity.

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Considering the example above, assume that your client has come to you for advice before she files the late Form 3520.  The client she tells you that she received the gift 5 years ago but has heard that the IRS could still assess penalties, and that she has limited financial resources such that a large penalty would be financially devastating to her.  If she asks whether you recommend filing the Form 3520 reporting the foreign gift now, knowing that this will immediately result in a penalty of 25% of the amount of the gift, and that if the client likely would not be able to satisfy the IRS’s interpretation of the standard for reasonable cause and thus  would likely be unsuccessful in challenging a penalty, what is your advice?  Do you have an ethical duty to advise the client to file the delinquent Form 3520 despite knowing what the outcome will be?  How do you balance your duty to tax system and ethical obligations under Circular 230 with your duty to obtain the best possible outcome for your client And can you consider the likelihood that the client will be audited in giving advice as to whether she should file the late Form 3520? 

Before discussing the practitioner’s ethical duties, we will briefly review the common foreign information return filing requirements and penalties to provide context for this discussion. 

Basic Background on Foreign Information Return Penalties – Types and Amounts of Penalties

Foreign information return penalties include penalties for failure to file a host of forms that report U.S. taxpayer’s foreign assets and transactions.  The forms for which we most commonly see the assessment of penalties are 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 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts), and Form 3520-A (Annual Information Return of Foreign Trust with U.S. Owner), and other forms. Forms 3520 and 3520-A were the subject of an IRS Large Business and International “Campaign,” which the IRS discontinued on February 28, 2022. (We note that there are several other foreign information returns, but this article focuses on the forms for which we see the most IRS penalty action.

This post focuses only on the Title 26 foreign information return penalties and does not address the IRS’s enforcement of penalties for failure to file FinCen Form 114 (the “FBAR”), as those are not assessed under Title 26 (the Internal Revenue Code), but Title 31 (the Bank Secrecy Act). The rules for assessment and collection of FBAR penalties are contained in 31 U.S.C. § 5321..Failure to file Form 8938 (Statement of Specified Foreign Financial Assets) is also subject to penalties, but we have not seen the same level of enforcement of penalties as with the forms listed above.  This may change in the future, however, as the Treasury Inspector General for Tax Administration has criticized the IRS for its lack of enforcement in this area.  Additional Actions Are Needed to Address Non-Filing and Non-Reporting Compliance Under the Foreign Account Tax Compliance Act

The penalties for not filing Forms 5471 and 8938 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 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. See I.R.C. §§ 6038, 6038A, 6038B, 6038C, 6039F, 6677

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.”  As per Section 6677(c), 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.

The penalty for failure to file Form 3520-A, results in penalties of 5% of the “gross reportable amount.” The gross reportable amount for this penalty is “the gross value of the portion of the trust’s assets at the close of the year treated as owned by the United States person.”  If the IRS notifies a taxpayer of a failure to file the Form 3520-A, and the taxpayer does not file the form within the next 90 days, there is an additional penalty of $10,000 for each 30-day period (or fraction thereof) during which the failure to file continues, up to the gross reportable amount. I.R.C. §§ 6048(b); 6667(b), (c).

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.  Despite the policy statement in the Internal Revenue Manual that penalties should “be objectively proportioned to the offense,”( see IRM 20.1.1.2.1 (11-25-2011)) the IRS routinely assesses the maximum amount of foreign information return penalties even for short delays and where there is no tax due as a result of the late filing.

For all of the foreign information return penalties, reasonable cause is a defense.. 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 Advisory200748006. Many clients simply cannot meet this standard (at least as the IRS interprets it). These are taxpayers who were not willful and who did not intend to evade tax (and in many cases, there is no tax liability related to the late filing of the foreign information returns), but who may have been negligent or could have made a better effort at understanding their filing obligations.

In Notice 2022-36, the IRS recently provided some limited relief to taxpayers who had not filed, or had already been assessed penalties for late filing of, several different forms, including Forms 3520, 3520-A, and some Forms 5471. This relief is limited to the 2019 and 2020 tax years, and penalties “assessed by the campus assessment program” with respect to Forms 3520 and 3520-A (Annual Information Return of Foreign Trust with U.S. Owner).  The IRS also limited relief to taxpayers who were able to file their delinquent returns within the 37-day period between August 24, 2022, the date that IRS announced Notice 2022-36, and the September 30, 2022, deadline. In addition, Notice 2002-36 stated that the IRS will cancel penalty charges for those forms and years, and issue refunds, as appropriate. 

Notice 2002-36 provided cold comfort as it did not provide relief for earlier years and applied to a limited category of forms, and did not guarantee that the IRS would not assess penalties, only that they would not systematically assess them.  It is noteworthy that this limited relief was in no way a recognition of the harsh consequences to taxpayers from the systematic assessment of penalties.  The only stated reason for the relief was that there are better uses of IRS resources given its backlog after the pandemic and budget constraints, stating “[t]he Treasury Department and the IRS have determined that the penalty relief described in this notice will allow the IRS to focus its resources more effectively, as well as provide relief to taxpayers affected by the COVID-19 pandemic.”   Notice 2022-36 did not come close to alleviating the burdens on taxpayers who want to be compliant by filing delinquent foreign information returns. 

There are no other programs or procedures available for a taxpayer who has not understated their income to file a delinquent foreign information return without being subject to penalties.  Other than Notice 2022-36, which was of limited utility, the IRS has not offered a method of self-correcting with reduced penalties.  Instead, the only option for a taxpayer who wants to come into compliance is to file late and incur penalties.  Theoretically, a taxpayer could make a voluntary disclosure, but the penalty of 50% of the unreported offshore asset makes this option untenable, and the voluntary disclosure procedure is intended to apply in situations where the taxpayer has acted willfully and has concern about criminal liability, which is not the case where a taxpayer missed a filing deadline but does not owe any additional tax.

The IRS’s Streamlined Filing procedures are not available for taxpayers who do not owe any additional tax related to their non-compliance. This is an oddity of the current system – that a U.S. taxpayer who lives in the U.S., and has not reported income from a foreign asset is offered an opportunity to self-correct in exchange for payment of the tax and a reduced penalty of 5% of the value of the unreported foreign asset, while a taxpayers who lives in the U.S. and has not underreported their income will be subject to the maximum amount of penalties.

It is also important to note, as Les discussed in Tax Court To Consider IRS Procedure For Imposing Information Reporting Penalties, that 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 under Collection Due Process if the taxpayer is not offered review by the IRS Independent Office of Appeals).Despite the IRM allowing for pre-payment review, the IRS sometimes initiates enforced collection before the taxpayers have completed their appeal, and frequently sends collection notices, including notices of intent to levy, before the taxpayers’ deadlines to submit a protest has even passed.  This means that the taxpayer will receive a notice and demand for the payment and will not have any pre-assessment right to challenge the penalty or raise any defenses. The taxpayer should receive Appeals review, and also has a right to pay the penalty and bring a claim for refund, and then bring a suit in district court or the federal court of claims if the IRS denies the refund. Full payment and the Flora rule can impose a significant barrier. Moreover, these procedures are burdensome, and also may not be successful, as the taxpayer will have the burden of providing reasonable cause, which is the only defense available if the penalty was otherwise properly assessed.

This article does not discuss these procedures or likelihood of success, but merely notes, for the purposes of the issue under discussion (i) other than the returns filed under Notice 2022-36, the IRS frequently systematically assesses penalties for late filing of certain foreign information returns; (ii) the burden is on the taxpayer to challenge the penalty and raise any defenses; (iii) it is unlikely that the IRS or Appeals will abate the penalty without a strong showing of reasonable cause; and (iv) for most taxpayers, the only possibility for judicial review will be after they pay the penalty in full and file a refund claim.

In tomorrow’s post, we will discuss the ethical standards that practitioners must address when faced with a client’s failure to comply with the information reporting obligations discussed today.

Filed Under: Circular 230, Civil Penalties Tagged With:

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

April 21, 2021 by 4 Comments

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.

Filed Under: Circular 230, Designated Orders, Tax Court

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

April 20, 2021 by Leave a Comment

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.

Filed Under: Circular 230, Designated Orders, Tax Court

Counsel Clarifies the Limited Rights of Unenrolled Preparers in Tax Court Cases

April 24, 2017 by 1 Comment

Taxpayers who have filed a petition in Tax Court often still rely on their tax return preparers to help try to resolve the matter. Most unlicensed tax return preparers are not admitted to practice before IRS Counsel attorneys. Despite that, in a 2014 Chief Counsel notice the IRS emphasized that Counsel attorneys should interact with a taxpayer’s representative if there is a valid POA on file authorizing the representative to act on the taxpayer’s behalf.

Last week, in  Notice CC-2017-007 Counsel clarified its earlier procedure and discussed issues relating to a representative who is an “Unenrolled Return Preparer.”

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As we have discussed before, following the judicial rejection of the Service’s plan to require unlicensed preparers to pass a test and complete continuing education requirements, the Service launched a voluntary testing and education program called the Annual Filing Season Program (see for example Some More Updates on IRS Annual Filing Season Program and Refundable Credit Errors). Under that program, unlicensed preparers take 18 hours of continuing education and take a test on federal tax law. The return preparer seeking to obtain certification of compliance with the annal filing season program must also renew their preparer tax identification number (PTIN) and consent to adhere to and be subject to the obligations in Circular 230 addressing duties and restrictions to practice before the Service and Circular 230 § 10.51, which addresses sanctions and disreputable conduct. The benefits of opting in to the Annual Filing Season Program include becoming part of a searchable database of preparers and the right to represent taxpayers in examinations, though not before Appeals, Counsel or Collection.

That representation ability is a key perk for unenrolled preparers; it generally was available to all signing preparers before 2015 though by now limiting representation to the unenrolled preparers who comply with the Annual Filing Season Program, the Service has hoped to generate interest in and demand for what it required through its ill-fated mandatory testing and education regime.

Form 2848 specifically now has a designation for the class of unenrolled preparers who opt in to the Annual Filing Season Program; designation “h”, which is for “Unenrolled Return Preparer.”

Last week’s Chief Counsel notice discussed the limits of these representational rights for Unenrolled Return Preparers. Most importantly, representation is still limited to matters involving examination of a tax return. A challenge for the Service is drawing the line between assistance in an exam matter and in a matter that progresses beyond an exam because the taxpayer, often with shadow assistance by an unlicensed preparer, has filed a petition in Tax Court. Despite the limits of the representational powers of unenrolled return preparers, in the current Chief Counsel Notice the Service clarified that “if the involvement of an unenrolled return preparer is beneficial to the resolution of the case, Counsel attorneys may work with the unenrolled return preparer, in a non-representative capacity, to develop the facts of a case.”

In the Notice, Counsel thus takes a practical approach to the issue. Most cases in Tax Court involve pro se taxpayers, and many disputes in court revolve around facts. My experience is that in many instances the involvement of a third party can assist in the resolution of the case. The 2017 Chief Counsel Notice states that the preparer may assist the taxpayer in gathering information or in substantiation of items on the return, and that Counsel attorneys may permit the preparer to attend meetings.

The Notice does remind its attorneys to clarify with the taxpayer and the preparer that for the unenrolled return preparer there is no general authority to represent taxpayers in Tax Court cases, and that Counsel has no obligation to communicate with the preparer or even include the preparer in meetings if the preparer is abusive or if the interests of the preparer conflict with the interests of the taxpayer.

There are a couple of points worth highlighting in the Notice. First, with the increased reach of special due diligence penalties applying to more refundable credits, it is becoming somewhat more likely that a conflict between a preparer and a taxpayer may arise. In addition, as with other third parties who are not representatives of a taxpayer, Counsel’s communications with unenrolled preparers could expose the Service to possible 6103 violations if the communications proceed without the involvement of the taxpayer. As such, the Notice reminds its attorneys that it should communicate with the unenrolled preparer only if the taxpayer “is present, either in person or on the telephone, or in the unenrolled return preparer’s capacity as a third party record keeper or a potential witness.” In addition, because I suspect that taxpayers may not fully appreciate the limited powers of unenrolled preparers, the Notice states that to “avoid confusion Counsel attorneys should clarify with both the petitioner and the unenrolled return preparer that unenrolled return preparers do not have the authority to represent petitioners in dealings with Chief Counsel, even if the petitioner purports to consent to the representation.”

Conclusion

In sum, the Notice seems helpful for all parties. As taxpayers become more familiar with the limits associated with preparers who have not opted in to the Annual Filing Season Program, the Service encourages what it could not mandate; that is, the use of preparers who in fact have demonstrated some minimal level of competence and who demonstrate the additional accountability and visibility associated with the annual filing season program. I think that the approach of providing the incentive to use some preparers as compared to others, so long as that incentive is tied to furthering the goal of good tax administration rather than lining the pockets of some preparers over others, is a good model for IRS oversight over an industry that plays a key role in tax administration.

Filed Under: Circular 230, Return Preparer Regulation

Fee Arrangements are a Matter between Taxpayers and their Advisors

January 26, 2016 by 7 Comments

We welcome back guest blogger G. Brint Ryan, Chairman and CEO of Ryan, LLC. Brint wrote a guest blog post for us at the end of 2014 about a case we described then as perhaps the most important procedural case of the year combined with the Loving case.  He has continued to litigate concerning the issue of fees for service and the ability of the government to control the fee arrangement between parties.  The most recent case involves litigation with the state rather than the IRS but has implications that go beyond just the laws in California.  Keith

In an important win for business against government encroachment, a California Superior Court recently invalidated a rule restricting taxpayers from paying performance-based fees for professional services.  In this case, Ryan, LLC (“Ryan”) filed suit challenging the legality of an emergency rule promulgated by the California Governor’s Office of Business and Economic Development (“GO-Biz”) in August 2014, which sought to restrict performance-based fee arrangements for companies applying for the California Competes Tax Credit.  California Superior Court Judge Timothy M. Frawley ruled in favor of Ryan, stating that the “cost of a consultant’s services is a matter between the taxpayer and the consultant.” He found that the state had failed to show any link between these costs and the economic development goals of the program.

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This ruling is a win for businesses and the professionals who assist them in making their growth and investment decisions.

Federal, state, and local governments in the U.S. offer tens of billions of dollars annually in credits and incentives (like the California Competes Program) to businesses to promote job creation and economic development. However, due to the complexity of uncovering and applying for available credits and incentives, half of them go unclaimed each year. Firms like Ryan provide the advice needed to ensure that these incentives aren’t missed by growing businesses that are generating local jobs and economic opportunities.

Of the nearly six million employer firms in this country, companies with fewer than 500 workers accounted for 99.7% of those businesses. In other words, the businesses that make up the very backbone of the U.S. economy are the ones likely to engage a credits and incentives consultant. They are small to medium-sized and unlikely to have the experience, expertise, or bandwidth needed to properly research, identify, and negotiate business incentives. These smaller organizations are the most likely to need external counsel to assist them in unlocking incentives that will help expand their businesses by impacting their bottom line.

Adopting a performance-based fee structure, which pays a consultant only if that consultant successfully procures useful business incentives, is a “win-win” situation, especially for firms who can’t afford to pay these fees upfront. This is precisely why a ban on fee arrangements makes no sense. Restricting taxpayer contracts for professional services would only hamper the appetite and ability of businesses to apply for tax credits—producing a self-defeating result for any economic development program.

Judge Frawley agreed with this argument, writing that banning performance fee arrangements “does nothing to stimulate ‘new employment’ or ‘economic growth,’ and does nothing to encourage businesses to invest in California. The only thing the ban is likely to accomplish is [to] discourage businesses with contingent fee arrangements from participating in the California Competes tax credit program.”

Thus, ironically, losing this lawsuit is actual a “win” for the California economy. Removing this ban puts California back in line with the way other states operate. It opens the market back up for California as a business-friendly state and promotes the California economy.

In addition, the nature of the ban was inherently flawed and lacked a fundamental understanding of how performance-based fees work with regards to incentives. It restricted the fee structure for one particular tax credit. But companies that are considering expansions and relocations typically are not focused on a specific tax credit or incentive in a single state. For example, Ryan works on behalf of its clients to research and pursue any and all potentially available credits and incentives for each potential site so that the client can take all of them into account in determining the return on investment for a project. In general, because the services Ryan provides to its clients are interconnected, span multiple years and locations, and encompass a variety of different tax credits and incentives (national, state, regional, and municipal), the fees it charges cannot be isolated on a “per credit” basis.

Underscoring these arguments is the basic notion of fairness. It is unjust for government to intrude into a company’s business judgments to the point of dictating how a company pays its consultants. Ryan levied a similar blow to Internal Revenue Service (IRS) business regulatory overreach in 2014 in Ridgely v. Lew, which invalidated restrictions prohibiting attorneys, certified public accountants (CPAs), and other practitioners from entering into performance-based fee arrangements for services before the IRS (known as Circular 230 provisions).

This ruling on the California GO-Biz case is a win for businesses as well as economic development in the state of California. Ryan will continue to lead the charge against unfair and illegal government interference that infringes on the rights of taxpayers and inhibits economic growth.

 

 

Filed Under: Business, Circular 230 Tagged With:

Summary Opinions for week ending 02/27/15

March 17, 2015 by Leave a Comment

Before the roundup, a quick thank you to our guest posters from the week ending February 27th.  Michael Desmond joined us once again, posting on the likelihood of legislative responses to the court’s stopping regulation of paid preparers.  We also welcomed Marilyn Ames as a first time poster, writing about the binding effect of an OIC.

To the procedure from that week:

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  • The Service issued Rev. Proc. 2015-16, which provides updated guidance on adequate disclosure for reducing accuracy related penalties and the tax return preparer penalties under Section 6694(a).  The Revenue Procedure appears to be very similar to the prior guidance found in Rev. Proc. 2014-15, and reincorporates some examples from the guidance in 2013, which the Service decided it should not have removed.
  • The facts of a substantial valuation misstatement penalty case in Na v. Commissioner, which the taxpayer won, are fairly interesting.  In Na, the Service used the bank deposit method to recreate a taxpayer’s income.  Prior to the year in question, the taxpayer did not have much annual income and never gambled.  The taxpayer also spoke little English.  During the audited year, the taxpayer had income and deposits of over a $1M in gambling earnings, plus substantial distributions from her employer’s companies.  She explained that her employer used her personal accounts to run distributions from his companies and his gambling activity through.  The Court found her evidence and testimony credible, and greatly reduced her liability.  The Court did not address the specifics of the substantial valuation penalty, and instead said that was for the parties to review and calculate following the order.  Anyone want to give odds on the chances of seeing a TC case in the employer’s name in the near future?
  • The Service issued Rev. Proc. 2015-20, providing updated guidance for small businesses tying to comply with the final tangible personal property regulations issued in 2013 regarding capitalization of costs regarding TPP.  The Service has also promulgated some FAQs on the topic.  There has been a lot of consternation regarding whether or not these will require all businesses to request a change in accounting method and file Form 3115.  For some small businesses, the Form will not be required.
  • From the legal gossip blog, Above the Law, comes a glowing recommendation for the TV show Better Call Saul, stating that it is a far more accurate representation of the practice of law than most other legal shows.  I’ve watched the first few episodes, and am completely hooked.  In full disclosure, I was a huge fan of Breaking Bad, and this is a spin off.  Not particularly representative of my life though.  I had far less anguish over hush money and the persuasive power of violence.
  • The Tax Court held that state law applied in determining what the successor in interest was for an entity that transferred assets to a related taxpayer.  See TFT Galveston Port. LTD v. Comm’r.
  • IRS scams on the front page of CNN.
  •  Last August, we touched on FDIC v. AmFin in SumOp, which was based on a dispute over ownership of a refund issued to the parent of a consolidated group.  SCOTUS didn’t find the issue that interesting, and denied cert.
  • Do banks get title insurance before foreclosing on properties?  The District Court for the Southern District of Indiana in First Financial Bank v. US Dept. of Treas. tossed an action for quiet title filed by the bank where a subsequent title search turned up a tax lien after a deed in lieu of foreclosure.  The Court found that the Service met its burden under Section 7425 in that it had a valid lien, which was recorded at least thirty days prior to the sale, and the Service wasn’t given notice of the sale.
  • In the saga that is the Aloe Vera unlawful disclosure case, Aloe Vera won a significant (although not monetarily) victory last month.  The District Court for the District of Arizona found the IRS wrongfully disclosed to the Japanese taxing authority confidential return information, which was actually found to be false and the Service knew the same at the time of disclosure.  Unfortunately, for Aloe Vera, no actual damages were found, so the statutory damages were the extent of the recovery.

Filed Under: Circular 230, Civil Penalties, Disclosure, Gross valuation misstatement, Lien, Offer in Compromise, refund claim, Return Preparer Regulation

Legislative Authority to Regulate Paid Tax Return Preparers: The Focus Turns to Congress to Act

February 26, 2015 by Leave a Comment

In this post, Michael Desmond of The Law Offices of Michael J. Desmond, APC discusses the prospects for a legislative response to recent court decisions enjoining the IRS from regulating paid tax return preparers and, more broadly, calling into question the scope of the IRS’s authority to promulgate practice standards under Circular 230.  This follows up on prior posts Mike has written on related topics: Is there a Future Role for Circular 230 in the IRS’s Efforts to Improve Compliance and one of PT’s most-viewed posts, Final Circular 230 Written Tax Advice Regulations. Les

Background

Section 330 of Title 31 (“Section 330”) provides the statutory basis for the Treasury Department and the IRS to promulgate the practice standards set forth in Treasury Department Circular 230. In its present form, 31 U.S.C. § 330(a)(1) authorizes the Secretary to “regulate the practice of representatives before the Treasury.” For decades, Treasury and the IRS have relied on this statute as authority for the regulation of a wide variety of “practitioner” conduct ranging from the due diligence standards in Circular 230 § 10.22, to the fee practices in § 10.27, to the conflict of interest rules in § 10.29 and the “written advice” standards in new § 10.37. Section 330(a)(2) of Title 31 complements Section 330(a)(1) by authorizing the Secretary to sanction (including by suspension or disbarment from “practice”) a “representative” who is incompetent, disreputable, violates regulations promulgated under Circular 230 or, in certain cases, misleads or threatens a “person being represented” or “prospective person to be represented.” Treasury and the IRS have relied on this authority to regulate a list of “incompetent” or “disreputable conduct,” ranging from conviction of certain crimes to “willfully” failing to electronically file a tax return when otherwise required to do so. See Circular 230 §§ 10.51(a)(1) through 10.51(a)(18).

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Both subsection (a)(1) and subsection (a)(2) of Section 330 are linked to the “practice” of a “representative,” terms that are not defined by the statute and, until recently, had not been interpreted by the courts. In 2004, Congress amended Section 31 to add a new subsection (d), which provides a negative grant of authority for the Treasury Department and IRS to regulate the rendering of written tax advice with respect to certain potentially abusive transactions. American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418, §§ 822. Neither the 2004 statute nor its legislative history address the definition of “practice” or “representative” as those terms are used elsewhere in Section 330.

Although Section 330 and its predecessor statutes have been in place largely unchanged for over a century, the government’s reliance on the statute to regulate as “practitioners” individuals who directly and indirectly interact with the federal tax system had not been subject to serious challenges until recently. Amendments to Circular 230 finalized in 2011 attempted to regulate as “practitioners” persons whose only connection to the tax system was the preparation of tax returns for compensation changed that.

Loving and Ridgely

The D.C. Circuit’s decision in Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014) and the D.C. District Court’s decision several months later in Ridgely v. Lew, 2014 U.S. Dist. LEXIS 96447 (D.D.C. July 16, 2014) have introduced a new paradigm to Circular 230, calling into question key portions of the regulations and creating a watershed moment for the regulation of a broad range of tax advisor conduct. With the decisions in both cases now final, attention has shifted from the courts to Congress to address what are generally agreed to be serious compliance problems created by a system where hundreds of thousands of unregulated, unlicensed and in many cases untrained professionals assist tens of millions of taxpayers in paying and obtaining refunds of billions of dollars in taxes each year.

Summarizing Loving and Ridgely:

  • In Loving, the D.C. Circuit considered the “precise question” of “whether the IRS’s statutory authority to ‘regulate the practice of representatives of persons before the Department of Treasury’ encompasses authority to regulate tax-return preparers.” Finding no ambiguity in Section 330, the court held that it did not, walking through “six considerations [that] foreclose the IRS’s interpretation of the statute.”
  • While in Loving, the D.C. Circuit focused narrowly on newly promulgated provisions in Circular 230 that imposed testing and continuing education requirements on paid tax return preparers, the District Court’s decision in Ridgely v. Lew extends the D.C. Circuit’s holding in a context with potentially far broader consequences. While the only aspect of Circular 230 directly at issue in Ridgely was the limitation on contingent fees in Section 10.27 as applied to a CPA’s preparation of “ordinary refund claims,” the rationale of the case has wider application. The District Court equated paid tax return preparation to the preparation of “ordinary” refund claims and held that if—under Loving—the former does not constitute “the practice of representatives,” neither does the latter. And, if regulating the preparation of “ordinary refund claims” is beyond the scope of the IRS’s regulatory authority, so is regulating fee practices with respect to that activity.
  • While Ridgely was, by its terms, limited to contingent fee practices for refund claims, its rationale can be applied broadly to a wide range of conduct that Circular 230 has long purported to regulate, including due diligence, standards for written tax advice and conflicts of interest – none of which necessarily arise in the context of direct representation of taxpayers before the IRS. In sum, were it passed in its current form, S. 137 would address Loving and authorize the IRS to regulate paid tax return prepared, but it would not address Ridgely or future cases that can be expected to arise attempting to extend Ridgely to other conduct that is only indirectly related to an interaction with the IRS.
  • Although the Ridgely Court’s rationale may be a lineal extension of Loving, it does not necessarily hold up against the “six considerations” the D.C. Circuit walked through in Loving. For example, unlike paid return preparation, the IRS has historically taken the position that it can regulate a CPAs’ fee practices. Moreover, Loving does not specifically address the secondary argument rejected in Ridgely that the IRS has derivative authority to regulate all aspects of conduct for persons who are, in other contexts, admittedly agents or “representatives” of taxpayers before the IRS (i.e., lawyers, CPAs and enrolled agents who at some point have filed an IRS Form 2848, Power of Attorney). This raises an interesting theoretical question as to whether the outcome might have been different had Ridgely reached the D.C. Circuit before Loving. Regardless, the Ridgely court did extended Loving to invalidate the limitation on contingent fees in Circular 230 § 10.27 and no appeal was taken.

With the government having folded its tent, at least for the moment, on further litigation over the scope of authority under Section 330, the focus now shifts to Congress for a solution.  While the prospects for expanding the IRS’s regulatory authority in the current political environment are unclear, the need for an updated statute – even before Loving and Ridgely is not.

The Horse Act of 1884

A downside to using a statute enacted 130 years ago as the basis for any modern day regulation, much less regulation of a multi-billion dollar industry, is that the language of the statute may not be up to the task at hand. When the predecessor to Section 330 was enacted, the United States did not have a generally applicable income tax, much less an entire industry focused on paid return preparation. Reading the original statute, it is difficult to imagine that in 1884 Congress thought that it was authorizing anything remotely close to the regulation of tax return preparers. Rather, when the original statute was enacted as part of the Horse Act of 1884, Congress was focused on funding claims brought against the War Department “[f]or horses and other property lost” during the Civil War. In authorizing that funding, Congress qualified it with the proviso:

 

That the Secretary of the Treasury may prescribe rules and regulations governing the recognition of agents, attorneys, or other persons representing claimants before his Department, and may require of such persons, agents and attorneys, before being recognized as representatives of claimants, that they shall show that they are of good character and in good repute, possessed of the necessary qualifications to enable them to render such claimants valuable service, and otherwise competent to advise and assist such claimants in the presentation of their cases.   And such Secretary may after due notice and opportunity for hearing suspend, and disbar from further practice before his Department any such person, agent, or attorney shown to be incompetent, disreputable, or who refuses to comply with the said rules and regulations, or who shall with intent to defraud, in any manner willfully and knowingly deceive, mislead, or threaten any claimant or prospective claimant, by word, circular, letter, or by advertisement.

Act of July 7, 1884, ch. 334, 23 Stat. 236, 258-59.

Submission of claims to the Treasury Department having evolved in the past 130 years from dead horses to home buyer, health insurance and earned income tax credits, among myriad other tax expenditures, the statutory grant of authority is in dire need of an update. As the D.C. Circuit stated in Loving in holding that Section 330 did not authorize the regulation of paid preparers, “we are confident that the enacting Congress did not intend to grow such a large elephant in such a small mousehole.” 742 F.3d at 1021.

Prospects for a Legislative Response

The judicial framework of Loving and Ridgely and the historical background of the Horse Act of 1884 provide context for evaluating recent legislative proposals to amend Section 330 to authorize the regulation of return preparers. Legislation introduced in prior Congresses focused on mandating regulation where historically the IRS had been unwilling or unable to do so. See, e.g., H.R. 1528, The Tax Administration and Good Government Act , § 4 (108th Cong.).   Those earlier legislative efforts met resistance on several fronts, including a concern expressed by the IRS that it lacked the resources to effectively regulate hundreds of thousands of paid preparers, a concern expressed by existing “practitioners” that the market value of their credentials not be eroded by a regulatory stamp of approval for all paid preparers, and a concern by unregulated paid preparers over the burden that would be imposed by any regulation. With no traction on the legislative front and a growing concern over unregulated preparers, Treasury and the IRS acted on their own with the promulgation of the 2011 amendments to Circular 230 making all paid return preparers “practitioners.” This shifted the target from Congress to the IRS, but did nothing to eliminate the underlying concerns. In short order, those concerns gave rise to litigation.

In the early days of the 114th Congress, legislation was again introduced to authorize the Treasury Department and IRS to regulate paid return preparers, now with the contextual benefit of Loving and Ridgely.   On January 8, 2015, Senators Wyden (D-Ore.) and Cardin (D-Md.) introduced S.137, which would amend Section 330 to supplement the current authorization for regulating “the practice of representatives of persons before the Department of Treasury” by adding a new subsection specifically authorizing regulation of “the practice of tax return preparers” as defined in Code section 7701(a)(36). If enacted, S. 137 would overturn Loving and authorize (presumably on a prospective basis) the changes to Circular 230 finalized in 2011 that attempted to fold paid return preparers into the definition of “practitioners.” The Obama Administration takes a similar albeit less detailed approach in its Fiscal Year 2016 Revenue Proposals, which call for legislation that “would explicitly provide that the Secretary has the authority to regulate all paid return preparers.” Similar legislation was also introduced in the 113th Congress without any meaningful action being taken on it. H.R. 4470, Tax Return Preparer Accountability Act of 2014, (113th Cong. 2014); H.R. 4463, Tax Refund Protection Act of 2014, H.R. 4463, 113th Cong. (2014); H.R. 1570, Taxpayer Protection and Preparer Fraud Prevention Act of 2013, 113th Cong. (2013).

While S. 137 responds to Loving,it does not address the broader challenge to the authority of the Treasury Department and IRS to regulate conduct beyond return preparation that was called into question by Ridgely. This is a somewhat ironic result, given that the district court in Ridgely purported to simply apply the holding in Loving, interpreting the meaning of “practice of representatives of persons before the Department of the Treasury.” By adding a new subsection to Section 330 providing targeted authority for Treasury and the IRS to regulate paid return preparers, S. 137 would appear to leave untouched the Ridgely court’s holding (applying Loving) that “the practice of representatives” under current law is limited to persons having direct “representative” interaction with the IRS and does not extend broadly to fee practices for preparing amended returns even with respect to persons who, like the plaintiff in Ridgely, are admittedly “practitioners” in other contexts.

S. 137 follows a discussion draft of legislation released by then Senate Finance Committee Chairman Max Baucus in 2013 as part of a broader package of proposals to reform the administration of federal tax law. That draft “clarifies” Section 330 by adding a reference to “preparing and filing . . . tax returns” to subsection (a)(2)(D). The draft assumes the threshold conclusion that “practice of representatives” includes return preparation, an issue that would have to be addressed in light of Loving. Moreover, like S. 137, the draft legislation does not address the narrow interpretation of “practice of representatives” in Section 330(a)(1) adopted by the District Court in Ridgely.  Despite these issues, inclusion of a proposal to amend Section 330 in the prior discussion draft suggests that the issue will be addressed again by the Finance Committee as Chairman Hatch continues to push for broader tax reform in the current Congress.

Also on the legislative front, the ABA’s Section of Taxation recently issued a Report supporting a legislative response to Loving, although the Report has yet to be adopted by the ABA’s House of Delegates. Like S. 137, the Report recommends that Section 330 be amended to include “tax return preparers” (as defined by Code section 7701(a)(36)) within the scope of Sections 330(a) and (b). While the Report does not propose specific legislative language, its recommendation could be implemented by expanding the definition of “practice of representatives,” which would address the holdings of both Loving and Ridgely. The Report also recommends amendments to Section 330(d), originally enacted in 2004, to expand it beyond a negative grant of authority applicable only to written tax advice rendered in the context transactions that have the potential for abuse.

Conclusion

Although the near-term prospects for legislation expanding the IRS’s regulatory authority may be remote, there does seem to be a broad consensus that paid tax return preparers should be subject to some form of uniform regulation and that the IRS should be able to promulgate practice standards applicable to a broad range of advisor conduct.   Loving and Ridgely make clear, however, that the Horse Act of 1884 is not up to the task of supporting that regulatory initiative. Whether it comes as part of a broader tax reform effort, or with narrower legislation targeted at improving the administration of the tax law, legislative action at some point in time seems inevitable. Legislation introduced in the current and past Congresses provide a good start and, with some refinement, should help to ensure the shared goal of improving compliance and tax administration. Only the minor challenge of moving tax legislation stands in the way.

 

 

Filed Under: Circular 230 Tagged With:
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