Man Bites Dog – Estate Wins Penalty Case Regarding Late Filed Return

In the case of Estate of Agnes R. Skeba v. United States; No. 3:17-cv-10231 (D. N.J. 2020), the court reconsidered and vacated an earlier opinion concerning the late filing penalty and determined both that the IRS wrongly interpreted the statute in imposing the penalty on these facts and that the estate had reasonable cause for filing the return late.  Several years ago I wrote that, when you see a citation to United States v. Boyle, 469 U.S. 241, 246 (1985) in an opinion, expect the worst if you are a taxpayer.  This case throws out that convention along with others.  I’m not sure that we have seen the last of this case, but I am sure that many taxpayers will start citing this opinion as they seek to avoid the late filing penalty.

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The facts of the case show an estate that was pretty diligent about trying to pay its taxes and, in fact, one that overpaid its taxes — which is why this case ends up in district court rather than the Tax Court.  The decedent had an estate valued at close to $15 million, much of which was farm land and equipment.  The estate had a liquidity problem with respect to the payment of taxes.  (This raises a question concerning IRC 6161 which is not answered by the opinion and which I cannot answer.)  The estate also had other problems because of will contests.  It used available funds to pay the inheritance taxes due in New Jersey and Pennsylvania and to partially pay the taxes due to the IRS.  It made an initial payment to the IRS of $725,000.  It knew that it was not paying enough to the IRS and was actively trying to borrow money to make the balance of the payment it calculated the estate would owe.  Closure on the loan was delayed, causing the estate to pay the balance of the anticipated liability, $2,745,000, a little more than nine months after the decedent’s date of death.

Because of uncertainty created by the litigation, the estate requested an extension of time to file the estate tax return.  The IRS granted the estate a six month extension; however, the estate did not file the return during the extension period and filed it almost nine months after the extended period had ended.  During this period there were delays in the state court litigation caused by the illness of the named executor and the attorney for the estate.  Once the estate filed the return, the IRS assessed the reported liability, which turned out to be about $900,000 less than the estate had paid in estimated payments.  This seems like a happy ending for the estate; however, the IRS imposed a late filing penalty on the estate arguing that the estate had not fully paid its liability at the time the return was due and that it did not timely file the return.  It calculated the penalty based on the difference between the timely payment of $725,000 and the estate tax liability of $2,528,838.  Because the return was filed more than five months late, the IRS multiplied 25% times the difference between the liability and the timely payment ($1,803,838) resulting in a penalty of $450,959.50 and a net “Overpayment” of $488,719.34 which it cheerfully refunded to the estate.  The estate, however, was not cheerful over this result.

The estate brought a refund suit seeking to recover the penalty amount.  The district court initially held for the estate; however, the IRS argued that the court applied the wrong standard in its initial opinion.  The IRS asserted that the de novo standard of review is appropriate for assessing the issue of whether the estate demonstrated reasonable cause and not willful neglect in failing to timely file its estate tax return; whereas the Court’s original memorandum used the arbitrary and capricious standard.  The Court vacates its prior memorandum and files this superseding memorandum in its place.

The court starts its analysis by giving a nod to Boyle:

[T]he law has evolved in estate tax matters to acknowledge that the estate bears the burden in proving that it has exercised ordinary business care and prudence in the event it filed a late return. United States v. Boyle, 469 U.S. 241, 246 (1985) (quoting 26 CFR § 301.6651(c)(1) (1984)).


In Boyle, Chief Justice Burger addressed “whether a taxpayer’s reliance on an attorney to prepare and file a tax return constitutes ‘reasonable cause’ under § 6651(a)(1) of the Internal Revenue Code, so as to defeat a statutory penalty incurred because of a late filing.” Id. at 242. According to 26 CFR § 301.6651-1(c)(1), a taxpayer filing a late return must show that he or she exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time. Id. at 243. Chief Justice Burger reasoned there was an administrative need for strict filing requirements.

Having given the obligatory nod to Boyle, the court then sets off on its own analysis of the statute and how, in the facts of this case the late filing of the return does not trigger the penalty:

In the Court’s view, the resolution of this matter hinges on an interpretation of a section of the IRS Code (26 C.F.R. § 6651) called “Failure to file tax return or to pay tax.” . . .

Generally, § 6651 addresses the assessment of penalties for late filing of a return, and late payment of taxes due. More specifically, the penalty under § 6651(a)(1) addresses the failure to file a timely return:

In case of failure (1) to file any return on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate. . . . 26 U.S.C. § 6651(a)(1). . . .

The calculation of the penalty imposed for failure to timely file a return (subsection (a)(1)) and failure to timely pay the tax (subsection (a)(2)) is clarified in § 6651(b). It declares:

(b) Penalty imposed on net amount due. For purposes of —

(1) subsection (a)(1), the amount of tax required to be shown on the return shall be reduced by the amount of any part of the tax which is paid on or before the date prescribed for payment of the tax and by the amount of any credit against the tax which may be claimed on the return,
(2) subsection (a)(2), the amount of tax shown on the return shall, for purposes of computing the addition for any month, be reduced by the amount of any part of the tax which is paid on or before the beginning of such month and by the amount of any credit against the tax which may be claimed on the return[.]
§ 6651(b).

The parties disagree on how to construe these provisions. Plaintiff proffers two arguments in support of its position. First, Plaintiff argues that § 6651(a)(1) should be read together (in pari materia) with § 6651(b)(1). In reading these subsections together, Plaintiff concludes that the late filing penalty is calculated by using the formula set forth in subsection (a)(1), incorporating the “net amount due” on the “the date prescribed for payment” as set forth in subsection (b)(1). Since the estate tax was overpaid on March 18, 2014 and the extension ran until September 10, 2014, there was no net amount due on the September deadline; and hence, no penalty may be imposed.

Secondly, and in the alternative, Plaintiff argues that the phrase “such failure is due to reasonable cause not due to willful neglect” in subsection (a)(1) protects the taxpayer from a penalty if the return was filed late due to a reasonable cause.

The Government disagrees with the taxpayer’s arguments. The Government proffers that the requirements of § 6651(a)(1) and (b) must be construed with another statute (26 U.S.C. § 6151) entitled “Time and place for paying taxes shown on returns.” . . . More specifically, § 6151 reads in pertinent part:

(a) General rule. Except as otherwise provided in this subchapter [26 USCS § 6151 et seq.] when a return of tax is required under this title or regulations, the person required to make such return shall, without assessment or notice and demand from the Secretary, pay such tax to the internal revenue officer with whom the return is filed, and shall pay such tax at the time and place fixed for filing the return (determined without regard to any extension of time for filing the return).
* * *
(c) Date fixed for payment of tax. In any case in which a tax is required to be paid on or before a certain date, or within a certain period, any reference in this title to the date fixed for payment of such tax shall be deemed a reference to the last day fixed for such payment (determined without regard to any extension of time for paying the tax).

Id. Based on § 6151, the Government cleverly reasons that the last day for payment was nine months after the death of Agnes Skeba — March 10, 2014; because no return was filed by that date a penalty may be assessed. Applying the rationale to the facts, the Government contends only $750,000 was paid on or before March 10, 2014, when $2,528,838 was due on that date. Referring back to § 6651(a)(1), a 25% penalty on the difference may therefore be assessed because it was not paid by March 10, 2014. As such, the full payment of the estate tax on March 18, 2014 is of no avail because the “last date fixed” was March 10, 2014. Accordingly, the Government argues that the imposition of a penalty in the amount of $450,959.00 is appropriate.

The IRS’s arguments miss the mark. First, both §§ 6651(a)(1) and (a)(2) designate the specific day on which penalties will be assessed for both late filing and payment of the estate tax return. Both paragraphs specify that the “date prescribed” is to “be determined with regard to any extension of time for filing.” The language of the statute in dispute is the one which is given precedence over a more generic statute like § 6151. See La Vallee Northside Civic Asso. v. V.I. Coastal Zone Mgmt. Com., 866 F.2d 616, 621 (3d Cir. 1989); see also Meyers v. Heffernan, No. 12-2434 (MLC), 2014 WL 3343803, at *8 (D.N.J. July 8, 2014).

After finding that the statutory language does not support the application of the penalty in this situation, the court goes on to find that the estate had reasonable cause for its late filing:

In this case, Mr. White [the estate’s attorney] submitted his August 17, 2015 letter explaining the rationale for not filing. For example, in Mr. White’s letter, he indicated that certain estate litigation was delayed due to health conditions suffered by the executor. Additionally, Mr. White refers to the Hoagland law firm and one of the attorneys assigned to the case as having been diagnosed with cancer. The Hoagland firm is a very prestigious and professional firm and based on same, Mr. White’s letter shows a reasonable cause for delay.

In addition, Mr. White’s prior letter of March 6, 2014 notes that there was difficulty in “securing all of the necessary valuations and appraisals . . . caused by the contested litigation.” Drawing from my professional experience, such appraisals often require months to prepare because a farm located in Monroe, New Jersey will often sit in residential, retail, and manufacturing zones. To appraise such a farm requires extensive knowledge of zoning considerations. Thus, this also constitutes a reasonable cause for delay.

Both aspects of the opinion will get cited by estates seeking to avoid the heavy hand of the late filing penalty when applied to significant estate tax liabilities.  As I mentioned above, I will be surprised if the IRS does not appeal this decision.  While I may have my doubts that the opinion will stand, it is one of many cases that points out the harshness of the application of Boyle.  The estate here made a significant effort to pay the tax.  The legal basis for the ruling could be a game changer for estates that make full payment before an extended due date.  I realize not every estate can meet that criteria.  Certainly, the case is worth following.

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. 

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.”)

Impact of Fraud Penalty on Only One Spouse

The case of Chico v. Commissioner, T.C. Memo. 2019-123 points out the benefits to the “good” spouse when the other spouse files a fraudulent tax return.  The case follows earlier Tax Court precedent established in the non-precedential case of Said v. Commissioner, T.C. Memo. 2003-148.  Because of the interplay of the fraud penalty and the accuracy related penalties, the “good” spouse gets a pass on penalties on the return.  While this outcome has nothing to do with the innocent spouse provisions, it has the effect of leaving the “good” spouse free of penalties when the fraud on the return relates only to the other spouse.  Thanks to our fellow blogger Jack Townsend for bringing this case to my attention.

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Mr. Chico ran several businesses including a return preparation business.  He filed returns that failed to report income from several sources and otherwise contained errors that caused the IRS to assert the fraud penalty.  When the IRS asserts the fraud penalty on a joint return, it must prove fraud of each spouse in order to have the fraud penalty apply to both spouses.  Here, Mr. Chico’s knowledge of the businesses and of return preparation made him the obvious target of the penalty while the IRS could not overcome the showing that Mrs. Chico had little knowledge of the matters on the return.  So, the court found the fraud penalty with respect to Mr. Chico but not his wife.

The finding of the fraud penalty against Mr. Chico did not end the pursuit of penalties by the IRS.  As it normally does, the IRS had asserted the lesser penalties in the accuracy penalty provisions of IRC 6662 against both husband and wife.  Here, the issue of penalty stacking comes into play.  The IRS cannot hit someone with the fraud penalty and the accuracy related penalty.  It can either obtain the fraud penalty or the accuracy related penalty but not both.  Because of the anti-stacking provision found in IRC 6662(b), the Tax Court found that it could not impose an accuracy related penalty against Ms. Chico since doing so would create a stacking of penalties.

IRC § 6662(b) states the following as it pertains to the imposition of accuracy-related penalties on underpayments.  The IRS may not stack penalties when any of the following apply:

  • When a penalty is imposed under IRC § 6663 (fraud penalties)
  • When a penalty is determined as being a “gross valuation misstatement” as defined under IRC § 6662(h)(2), the portion of the underpayment shall be penalized 40 percent in total (and not an additional 40 percent to the standard 20 percent penalty)
  • When a penalty is determined from a nondisclosed noneconomic substance transaction as defined under IRC § 6662(i), the portion of the underpayment shall be penalized 40 percent in total (and not an additional 40 percent to the standard 20 percent penalty)

Treas. Reg. 1.6662-2(c) is the anti-stacking provision in the CFR as it pertains to accuracy related penalties:

A. If a portion of the underpayment of tax shown on a return is attributable to both negligence and a substantial understatement, the accuracy-related penalty would apply only once at the 20 percent rate to this portion of the underpayment. The examiner should assert the penalty that is most strongly supported by the facts and circumstances and write up the other as an alternative penalty position.


B. The penalty is applied at the 40 percent rate on any portion of the underpayment attributable to a gross valuation misstatement. Any penalty at the 20 percent rate that could have applied to this portion is not asserted except as an alternative penalty position.


C. A penalty is applied at the 75 percent rate on any portion of the underpayment attributable to civil fraud. Any penalty that could have applied to this portion at the 20 or 40 percent rate is not asserted except as an alternative penalty position.

IRM 20.1.5.3.3.1 No Stacking Provision (12-13-2016) sets out the anti-stacking rules for IRS employees to follow. 

The application of the anti-stacking penalties allows Mrs. Chico to avoid having any penalty for filing an improper return assessed against her.  Although the IRS sought the accuracy related penalty against her it does not seem inclined to pursue the issue into the circuit courts to overturn the position stated by the Tax Court that imposing the lesser penalty on the spouse not liable for fraud creates impermissible stacking.  In the absence of a court challenge, the IRS must go to Congress and seek a change in the stacking rules to allow assessment against the spouse who did not commit fraud or forgo any lesser penalty against that spouse in these circumstances.

The spouse who did not commit fraud may still suffer because of the fraud.  Unless that spouse obtains innocent spouse relief, that spouse will owe all of the additional tax assessed as a result of the audit.  Unless the spouse who did not commit the fraud has no withholding and makes no estimated tax payments during the year, that spouse may have to repeatedly apply for injured spouse relief in subsequent years if the couple receives a refund of taxes since the IRS will likely take the whole refund to satisfy the penalty liability of the fraudulent spouse.

Here, the Chico’s filed a joint petition.  Two attorneys are listed in the opinion as representing the taxpayers.  It is not clear if one was representing Mr. Chico and the other Mrs. Chico or if they were both representing both parties.  This is a situation in which the attorneys must be careful because the interests of Mr. and Mrs. Chico do not align. 

This is also a situation in which Mrs. Chico was fortunate to have representation.  Without representation she has little chance of catching the mistake made by the IRS in seeking to impose a lesser included penalty on her.  Perhaps the Tax Court Judge would always or almost always catch this mistake and protect the unrepresented party but that puts a great deal of pressure on the judge which does not belong there.  Just because Tax Court judges do a good job of catching these issues and protecting unrepresented taxpayers does not mean that this is a perfect system.  An unrepresented taxpayer could end up owing a penalty which the IRS should not have imposed.  Even the accuracy related penalty would have been almost $40,000 for the three years at issue in this case.  That would have been a steep price for the unrepresented spouse to pay.

The court stated:

Respondent has not asserted fraud penalties against Ms. Chico but alleges that she is liable for the section 6662(a) accuracy-related penalty for each year at issue.

I interpret the court’s statement to mean that no penalty was asserted against Ms. Chico in the notice of deficiency but the attorney in Chief Counsel’s office decided to pursue the penalty after the filing of the petition.  If I have interpreted the situation correctly, it looks like the notice writers at the IRS read the IRM but the Chief Counsel attorney and supervisor did not or maybe Chief Counsel’s office does not agree with the decision in Said.  If I interpreted the situation correctly, maybe it’s time for a new Chief Counsel notice assuming that Chief Counsel’s office now agrees with this outcome.

Update on Haynes v US: Fifth Circuit Remands and Punts on Whether Boyle Applies in E-Filing Cases

One of the foundational principles in tax procedure is that reliance on an accountant or lawyer to file a tax return cannot in and of itself constitute reasonable cause to avoid a late-filing penalty. The Supreme Court said as much in the 1985 case United States v Boyle. Over the last few years taxpayers and practitioners have started to challenge Boyle in the e-filing context. The basic question is whether courts should reconsider the bright line Boyle rule when a taxpayer provides her tax information to her preparer and the preparer purports to e-file the return, but for some reason the IRS rejects the return and the taxpayer arguably has little reason to suspect that the return was not actually filed.

Sometimes the preparer may fail to receive a rejection notice from the IRS; sometimes the preparer gets the reject notice and fails to tell the client. In either situation, the client then gets a surprise letter from the IRS months or maybe years later, leading to late filing penalties.

In the case of the Hayneses, the taxpayers heard from their accountant/preparer that on the last day for filing their 2010 tax return he had in fact e-filed the return. But for some reason the Social Security Number erroneously appeared on the line designated for an employment-identification number, and the IRS rejected the return. The preparer did not get a reject notice and neither he nor his clients took any steps to confirm that the IRS processed the supposedly e-filed return. After eventually receiving IRS correspondence the taxpayers filed their return and paid a late filing penalty. They sought a refund for the penalty, first with the IRS and then after the IRS denied the claim in federal district court. The district court granted the government summary judgment, concluding that as a matter of law under Boyle the taxpayers could not rely on their accountant to satisfy a return filing obligation even if the return filing process in the 21st century differs in kind from what was done back in the Reagan years.

In last month’s brief opinion, the Fifth Circuit took a different approach to the dispute. While noting that the application of Boyle in the 21stcentury world of e-filing is an “interesting” issue, it remanded the case back to the district court. It did so because it believed that there was a factual dispute that the lower court needed to resolve before it could even get to the legal issue:

Whether it was reasonable for Dunbar [the accountant] to assume, based on the IRS’s silence, that it had accepted the Hayneses’ return or whether ordinary business care and prudence would demand that he personally contact the IRS to ensure acceptance is a genuine question of material fact for the jury to decide. Because Dunbar is the Hayneses’ agent, if a jury determines that his actions meet the reasonable-cause standard, it must find the same to be true for the Hayneses—barring any determination of independent negligence by them.   After all, principals are not only bound by their agents’ failures, as in Boyle, but also by their diligence.

If, as a matter of fact, it was reasonable for the accountant to assume that the IRS accepted the return without seeking confirmation, then the penalty does not stand. If, however, the jury finds it was not reasonable, then the 21st century Boyle issue is teed up:

It is this question of material fact that makes it unnecessary for us to decide whether a broad e-filing exception to Boyle exists. That complex question need only be answered if Dunbar, in fact, acted negligently in filing the Hayneses’ tax return. Only then would the Hayneses be relegated to relying solely on their reliance on Dunbar to meet the reasonable-cause standard, thereby teeing up the Boyle question.

Conclusion

We will closely follow this case, as well as the handful of other cases that are percolating in the courts that raise the issue.

For prior PT coverage on this issue, see our post on the lower court opinion in the Haynes case and our post discussing a similar issue in the Spottiswood case. Those posts generated thoughtful comments and also link to some other useful sources.

 

 

Designated Orders: 7/9/18 to 7/13/18

William Schmidt from the Kansas Legal Aid Society brings us this weeks designated orders. Three orders in cases involving the Graev issue keep that issue, no doubt the most important procedural issue in 2018, front and center. As with last week, there is an order in the whistleblower area with a lot of meat for those following cases interpreting that statute. Keith

For the week of July 9 through July 13, there were 9 designated orders from the Tax Court. Three rulings on IRS motions for summary judgment include 2 denials because there is a dispute as to a material fact (1st order based on employment taxes here) (2nd order involves petitioners denying both having a tax liability and receiving notice of deficiency for 2012 here) and a granted motion because petitioner was not responsive (order here). What follows are three orders where Judge Holmes takes on Chai ghouls, an exploration of a whistleblower case, and two quick summaries of cases. Overall, the Chai ghoul cases and whistleblower case made for a good week to read judicial analysis.

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Chai Ghouls

All three of these are orders from Judge Holmes that deal with Chai and Graev issues. The first two discussed were later in the week and had more analysis. As you are likely aware, the Chai and Graev judicial history in the Tax Court has led to several current cases that need analysis regarding whether there was supervisory approval regarding accuracy-related penalties, as required by Internal Revenue Code section 6751. In each of these cases, the IRS has filed a motion to reopen the case to admit evidence regarding their compliance with 6751(b)(1).

  • Docket Nos. 11459-15, Hector Baca & Magdalena Baca, v. C.I.R. (Order here).

The Commissioner filed the motion to reopen the record to admit the form. The Bacas couldn’t tell the Commissioner whether or not they objected to the motion. When given a chance to respond, they did not object. The Bacas did not raise Code section 6751 at any stage of the case (petition, amended petition, trial, or brief). The Commissioner conceded 6662(c) (negligence or disregard) penalties because the only penalty-approval form found is the one for 6662(d) (substantial understatement) penalties.

The Court’s analysis sets out the standard for reopening the record. The evidence to be added cannot be merely cumulative or impeaching, must be material to the issues involved, and would probably change the outcome of the case. Additionally, the Court should consider the importance and probative value of the evidence, the reason for the moving party’s failure to introduce the evidence earlier, and the possibility of the prejudice to the non-moving party.

The Court then analyzes those elements set out above. For example, the Court finds the penalty-approval form to be properly authenticated nonhearsay and thus admissible. Ultimately, the Commissioner had less reason to anticipate the importance of section 6751 because it was following Chai and Graev that it was clarified the Commissioner had the burden of production to show compliance with 6751 when wanting to prove a penalty.

In this case, the Court states because the Bacas did not object to the accuracy-related penalties, that is some excuse for the Commissioner’s lack of diligence. Additionally, the Court concludes that it can’t decide the Bacas would be prejudiced because they never said they would be.

Takeaway – Respond when the court requests your opinion or you may suffer consequences that could have been avoided if you had raised your hand and notified the court of your concerns.

  • Docket Nos. 19150-10, 6541-12, Scott A. Householder & Debra A. Householder, et al., v. C.I.R. (Order here).

This set of consolidated cases differ from the Bacas’ case because of an objection submitted by the petitioners. Arguments by the petitioners begin that the record should not be reopened because the Commissioner’s failure to introduce evidence of compliance with 6751(b)(1) shows a lack of diligence, and the Commissioner doesn’t offer a good reason for failing to introduce the form despite possessing it when trying the cases. They argue they would be prejudiced by reopening the record because they have not had a chance to cross-examine the examining IRS Revenue Agent on their case. They argue the form is unauthenticated and that both the declaration and the form are inadmissible hearsay.

Again, the form is found to be admissible nonhearsay. Regarding the authentication argument, the IRS recordkeeping meets the government’s prima facie showing of authenticity. The Court brings up that the Revenue Agent in question was a witness at trial that the petitioners did cross-examine, it’s just that they did not have section 6751 in mind at the time. In fact, the Court reviews a set of questions the petitioners listed and finds that those answers likely would not have helped them so comes to the conclusion that they would not be prejudiced by admitting the form.

Overall, both parties should have been more diligent to bring up section 6751. Since they did not, the lack of diligence on the Commissioner’s part is counterbalanced by the probative value of the evidence and the lack of prejudice to the petitioners if the record were reopened to admit the form.

Takeaway – The IRS is not the only party on notice of the Chai and Graev issue. Petitioners bear responsibility to raise the issue of supervisory approval just as the IRS has a responsibility to show proper authorization of the penalty. The court seems to be shifting a bit from prior determinations.

  • Docket Nos. 17753-16, 17754-16, 17755-16, Plentywood Drug, Inc., et al., v. C.I.R. (Order here).

These consolidated cases also deal with the 6751 accuracy-related penalties and the IRS motion to reopen the record to admit penalty-approval forms. While the petitioners originally disputed the penalties, they conceded penalties on some issues but did not want to concede penalties on others. As a result, they did not object to the Commissioner’s motion. The Court did not grant the motion regarding penalties determined against the corporate petitioner as it would not change the outcome of the case. In Dynamo Holdings v. Commissioner, 150 T.C. No. 10 (May 7, 2018), the Court held that section 7491(c)’s burden of production on penalties does not apply to corporate petitioners, so that, in a corporate case, where the taxpayer never asked for proof of managerial approval and so did not get into the record either a form or an admission that no form was signed, the taxpayer had the burden of production on this section 6751(b) issue and had failed. For the penalties determined against the individual petitioners, the Court granted the motion since they did not raise any objections.

In all three cases, the Court orders to grant the IRS motion to reopen the record to admit the penalty-approval form attached to the motion (with the exception of the denial of the application to Plentywood Drug, Inc.).

Comments: I must admit when Judge Holmes mentions Chai ghouls in his orders it makes me think of Ghostbusters (Chai ghoul bustin’ makes him feel good?). In looking over these three cases, it seems to me they have the same result no matter what the petitioners did. It is understandable when the petitioners never objected to the penalties or the approval form. However, the Householders objected and still got the same result. Perhaps I am more sympathetic to the petitioners, but the reasoning also does not follow for me that petitioners would not be prejudiced by admitting a form that allows them to have additional penalties added on to their tax liabilities. 

Whistleblowers and Discovery

Docket No. 972-17W, Whistleblower 972-17W v. C.I.R. (Order here).

By order dated April 27, 2018, the Court directed respondent to file the administrative record as compiled by the Whistleblower Office. Petitioner filed a motion for leave to conduct discovery, the IRS followed with an opposing response and the petitioner filed a reply to respondent’s response. On June 25, the Court conducted a hearing on petitioner’s motion in Washington, D.C., where both parties appeared and were heard.

Internal Revenue Code section 7623 provides for whistleblower awards (awards to individuals who provide information to the IRS regarding third parties failing to comply with internal revenue laws). Section 7623(b) allows for awards that are at least 15 percent but not more than 30 percent of the proceeds collected as a result of whistleblower action (including any related actions) or from any settlement in response to that action. The whistleblower’s entitlement depends on whether there was a collection of proceeds and whether that collection was attributable (at least in part) to information provided by the whistleblower to the IRS.

On June 27, 2008, the petitioner executed a Form 211, Application for Award for Original Information, and submitted that to the IRS Whistleblower Office with a letter that identified seven individuals who were involved in federal tax evasion schemes. The first time the petitioner met with IRS Special Agents was in 2008 and several meetings followed. The IRS focused on and investigated three of the individuals listed on petitioner’s Form 211 following those initial meetings.

The first taxpayer (and I use that term loosely for these three individuals) was the president of a specific corporation. In 2013, that individual was convicted of tax-related crimes including failing to file personal and corporate tax returns due in 2006, 2007, and 2008. This person received millions of dollars in unreported dividends (from a second corporation, also controlled by this individual). This individual was ordered to pay restitution of $37.8 million.

The second individual was the chief financial officer of the corporation. This person received approximately $13,000 per month from the corporation in tax year 2006 but failed to report that as taxable income, and did not file a tax return in 2007. After amending the 2006 tax return and filing the 2007 tax return, the criminal investigation ended. The Revenue Officer assessed trust fund recovery penalties for the final quarter of tax year 2006 and all four quarters of tax year 2007. This taxpayer filed amended tax returns for 2005 and 2006 in March 2009 and filed delinquent returns for 2007 and 2008 in July 2010. The IRS filed liens to collect trust fund recovery penalties of approximately $657,000 and income tax liabilities of $75,000 for tax years 2005 and 2006.

The third individual was an associate of the first two but had an indirect connection with the corporation. This taxpayer had delinquent returns for 2003-2011 and there was a limited scope audit for tax years 2009 and 2010. The IRS filed tax liens for unpaid income taxes totaling approximately $2.4 million for tax years 2003 to 2011.

For each of the individuals, the IRS executed a Form 11369, Confidential Evaluation Report, on petitioner’s involvement in the investigations. For taxpayer 1, the IRS Special Agent stated that all information was developed by the IRS independent of any information provided by petitioner. For taxpayer 2, the form includes statements the Revenue Officer discovered the unreported income and petitioner’s information was not useful in an exam of the 2009 and 2010 tax returns. For taxpayer 3, the form states the taxpayer was never the subject of a criminal investigation (which is inconsistent with the record) and that petitioner’s information was not helpful to the IRS.

The petitioner seeks discovery in order to supplement the administrative record, contending the record is incomplete and precludes effective judicial review of the disallowance of the claim for a whistleblower award. Respondent asserts the administrative record is the only information taken into account for a whistleblower award so the scope of review is limited to the administrative record and petitioner has failed to establish an exception.

The Court notes the administrative record is expected to include all information provided by the whistleblower (whether the original submission or through subsequent contact with the IRS). The Court’s review of the record in question is that it contains little information, other than the original Form 211, identifying or describing the information petitioner provided to the IRS. While the record indicates that there were multiple meetings concerning the three taxpayers, there are few records of the dates and virtually no documents of the information provided. The Court agreed with the petitioner that the administrative record was materially incomplete and that the circumstances justified a limited departure from the strict application of the rule limiting review to the administrative record.

The Court states the petitioner met the minimal showing of relevant subject matter for discovery since the administrative record was materially incomplete and precluded judicial review. The information petitioner seeks is relevant to the petitioner’s assertion that the information provided led the IRS to civil examinations and criminal investigations for the three taxpayers and led to the assessment and collection of taxes that would justify an award under section 7623(b). The IRS did not deny petitioner’s factual allegations and did not argue the information sought would be irrelevant so failed to carry the burden that the information sought should not be produced.

The Court limited petitioner’s discovery to three interrogatories concerning conversations with a Revenue Officer and two Special Agents, two requests for production of documents concerning notes and records of meetings with those three individuals.

Petitioner sought nonconsensual depositions if the IRS did not comply with the interrogatories and requests for production of documents. Since the Court directed the IRS to respond to the granted discovery requests, it is premature to consider the requests for nonconsensual depositions at this time. The footnote cites Rule 74(c)(1)(B), which calls that “an extraordinary method of discovery” only available where the witness can give testimony not obtained through other forms of discovery.

Respondent is ordered to respond to those specific interrogatories and requests for production of documents by August 17, 2018.

Comment: On the surface, this step forward looks to be a win for the petitioner as there seems to be a cause and effect that justifies a substantial whistleblower award. I discussed the case with an attorney with a whistleblower case in his background who commented that to get a whistleblower award the whistleblower had to be the first one to make the reporting and the information had to be outside public knowledge (though that was outside the tax world). From his experience, the government made it difficult to win a whistleblower award and I would say that looks to be the case here.

Miscellaneous Short Items

  • The Petitioner Wants to Dismiss? – Docket No. 11487-17, Gary R. Lohse, Petitioner, v. C.I.R. (Order here). Petitioner files a motion to dismiss for lack of jurisdiction, stating the notice of deficiency is not valid. The judge denies his motion because there is a presumption of regularity that attaches to actions by government officials and nothing submitted by the petitioner overcomes that presumption.
  • Petitioner Wants a Voluntary Audit – Docket No. 24808-16 L, Tom J. Kuechenmeister v. C.I.R. (Order here). Petitioner filed a motion for order of voluntary audit, also claiming that the IRS was negligent in allowing the third party reporter to issue the forms 1099-MISC for truck driving. As Tax Court is a court of limited jurisdiction, the Court cannot order the IRS to conduct a voluntary audit. While the petitioner was previously warned about possible penalties up to $25,000, this motion was filed prior to the warning so no penalty assessed for this motion. Petitioner’s motion is denied.

Takeaway: Each time here, the petitioner does not understand the purpose of the Tax Court. The petitioners may have come to a better result by treating Tax Court motions as surgical tools rather than as blunt weapons.

 

When Can An Entity Be Subject to Return Preparer Penalties?

I have been reading a lot of opinions discussing misbehaving tax return preparers. The IRS has a heavy arsenal it can deploy against those preparers short of criminal sanctions: civil penalties, injunctions and disgorgement are the main tools, all of which we have discussed from time to time. A recent email advice that the IRS released  explores when an entity that employs a return preparer can also be subject to return preparer penalties.

One way to think about the uptick in actions against return preparers is that the IRS has taken Judge Boasberg and others to heart when IRS lost the Loving case a few years ago.

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Part of the reason Judge Boasberg (later affirmed by the DC Circuit) tossed the IRS return preparer scheme out was that the IRS approach to including return preparation within 31 USC § 330 (which authorizes the Secretary to regulate “the practice of representatives of persons before the Department of the Treasury” )seemed to disregard or minimize the existing powers the IRS had to combat bad egg preparers:

Two aspects of § 330’s statutory context prove especially important here. Both relate to § 330(b), which allows the IRS to penalize and disbar practicing representatives. First, statutes scattered across Title 26 of the U.S. Code create a careful, regimented schedule of penalties for misdeeds by tax-return preparers. If the IRS had open-ended discretion under § 330(b) to impose a range of monetary penalties on tax-return preparers for almost any conduct the IRS chooses to regulate, those Title 26 statutes would be eclipsed. Second, if the IRS could “disbar” misbehaving tax-return preparers under § 330(b), a federal statute meant to address precisely those malefactors—26 U.S.C. § 7407—would lose all relevance.

As Judge Boasberg flagged, a key aspect of the IRS power to police return preparers is civil penalties under Title 26. Section 6694(b) provides a penalty for a preparer’s willful or reckless misconduct in preparing a tax return or refund claim; the penalty is the greater of $5,000 or 75% of the income derived by the tax return preparer from the bad return/claim.

The recent email advice from the National Office explored the Service’s view on whether the IRS can impose a 6694 penalty on the entity that employs a misbehaving return preparer as well as the individual return preparer who was up to no good.  The advice works its way through the statutory and regulatory definitions of return preparer under Section 6694(f), which cross references Section 7701(a)(36) for the definition of “tax return preparer.”

Section 7701(a)(36) provides that “tax return preparer” means any person who prepares for compensation, or who employs one or more persons to prepare for compensation, tax returns or refund claims.

The regs under Section 6694 tease this out a bit. Treasury Regulation § 1.6694-1(b) provides the following:

For the purposes of this section, ‘tax return preparer’ means any person who is a tax return preparer within the meaning of section 7701(a)(36) and § 301.7701-15 of this chapter. An individual is a tax return preparer subject to section 6694 if the individual is primarily responsible for the position(s) on the return or claim for refund giving rise to an understatement. See § 301.7701-15(b)(3). There is only one individual within a firm who is primarily responsible for each position on the return or claim for refund giving rise to an understatement. … In some circumstances, there may be more than one tax return preparer who is primarily responsible for the position(s) giving rise to an understatement if multiple tax return preparers are employed by, or associated with, different firms.

Drilling deeper the advice also flags Reg § 1.6694-3(a)(2), which sets out when someone other than the actual return preparer may also be on the hook for the 6694 penalty:

  1. One or more members of the principal management (or principal officers) of the firm or a branch office participated in or knew of the conduct proscribed by section 6694(b);
  2. The corporation, partnership, or other firm entity failed to provide reasonable and appropriate procedures for review of the position for which the penalty is imposed; OR
  3.   The corporation, partnership, or other firm entity disregarded its reasonable and appropriate review procedures though willfulness, recklessness, or gross indifference (including ignoring facts that would lead a person of reasonable prudence and competence to investigate or ascertain) in the formulation of the advice, or the preparation of the return or claim for refund, that included the position for which the penalty is imposed.

In the email, the Counsel attorney points to the above reg for the conclusion that  its “interpretation of Treasury regulation § 1.6694-3(a)(2) is that generally, the entity (corporation, partnership, or other firm entity) that employs a tax return preparer will simultaneously be subject to the penalty under section 6694(b) only if the specific conditions set forth in the regulation are met. Otherwise, only the individual(s) that is primarily responsible for the position(s) on the return or claim for refund that gives rise to the understatement will be subject to the penalty.”

The email does refer to a district court opinion case (affirmed by the Sixth Circuit) from a few years ago, US v Elsass, where the court found that the owner of an entity was a “tax return preparer” for the purposes of the return preparer penalty provisions. In that case, the owner was the sole owner and personally prepared a substantial number of the returns at issue and was in its view the moving force on the positions (a theft loss/refund scheme).

The upshot of the advice is that absent circumstances similar to Elsass, or the presence of conditions 1 and either 2 or 3 above in Reg 6694-3(a)(2), an entity that employs return preparers itself is likely not subject to penalties. That conclusion suggests that return preparers should be careful to document and review procedures that are in place to ensure that an employed preparer has supervision and, of course, to make sure that management follows those procedures.