Boyle and the AWOL Return Preparer: No Excuse for Late Filing

A recent case out of the Northern District of California, Willett v United States, illustrates the difficulty taxpayers face when trying to base a reasonable cause defense to the late filing of tax returns on the conduct of their return preparer.

I will summarize the facts and the court’s analysis.

read more...

The Willetts had filed an extension for the 2014 year. In August of 2015, they delivered their K-1s, W-2s and 1099’s to their longtime preparer, who was a CPA. After dropping off the documents, for about three months their preparer did not respond to their phone calls. In October, the preparer contacted the Willets and told them that she had been seriously ill, would prepare the returns upon her release from an extended care facility, and would pay any penalties and interest associated with the late filing.

After another month or so of not hearing from the accountant, in November Mrs. Willett visited her preparer’s house to get an update. The preparer assured Mrs. Willett that she would complete the return. Unfortunately, despite the Willetts’ repeated efforts to contact her, that was the last that time that they heard from her (she in fact passed away in early 2017).  

The Willetts alleged that by December of 2015 they actively sought a replacement but were unable to get someone until June of 2016 due to other preparers claiming that (1) they were too busy or (2) the return was too complex. By June of 2016, they found someone and hired another CPA, and they filed the return in September of 2016. 

When the Willetts filed the delinquent return, IRS assessed over $34,000 and $6,000 of late filing and late payment penalties. The Willetts paid the penalties and filed a timely refund claim, alleging that their late filing should be excused based on their reasonably relying on their longtime accountant to prepare and file the returns on their behalf.  The IRS rejected the claim, and the Willetts filed suit in federal court. 

In response to the complaint, the government filed a motion to dismiss based on Boyle.  In response to the motion to dismiss, the Willetts amended their complaint and included even greater detail about the efforts they made to contact their longtime preparer after they dropped their tax documents off in August of 2016.   

The additional facts did not help: 

The Willetts’ allegations do not sufficiently plead reasonable cause entitling them to a refund for the late-filing penalties. Their allegations illustrate that they relied on their CPA, Ms. Goode, who possessed the original copies of their tax documents, became seriously ill, and was unable to complete their 2014 tax return on time.  In their Amended Complaint, the Willetts attempt to salvage their claims by providing a detailed timeline of the failed attempts to contact Ms. Goode. However, this timeline fails to demonstrate ordinary care, because it merely illustrates the numerous attempts to contact Ms. Goode.  But those allegations plead no excuse for the late-filing other than reliance on the Willetts’ agent, which is not “reasonable cause” under Boyle.

The Willett opinion does not break new ground. It refers to a couple of cases where the Tax Court held that a nonresponsive or ill accountant does not constitute reasonable cause for late filing. 

It also distinguishes Conklin Brothers of Santa Rosa, a post Boyle 1993 Ninth Circuit case which “held, in the case of a corporate-taxpayer, that reliance on an agent can establish reasonable cause if the taxpayer shows that “it was disabled from complying timely”—e.g., where its agent’s conduct was beyond the taxpayer’s control or supervision.” In distinguishing Conklin the opinion notes  (unpersuasively) that no court has extended it to individuals. More persuasively, the opinion explains that even if Conklin’s limited exception did apply to individuals, the facts as alleged did not support a finding that the Willetts were disabled from complying with their filing responsibilities:

The Willetts seem to imply that Ms. Goode’s possession of the original tax documents “disabled” them from filing their taxes themselves, and prevented them from hiring another CPA. They allege that they made attempts to contact other CPAs, and that those other CPAs would not take them as clients. The insufficiency of these allegations is apparent when compared to other cases holding that the disability exception did not apply. In Conklin, the agent in charge of Conklin’s tax obligations, the corporation’s controller, failed to timely file Conklin’s returns.  For over two years the controller also “intercepted and screened the mail,” “altered check descriptions and the quarterly reports,” and “concealed the deficiencies by undertaking the performance herself of all payroll functions.”  Although the controller’s concealment meant that Conklin’s officers were not aware of the IRS’s penalty assessments, the Ninth Circuit held that the controller’s “intentional misconduct” was not enough to establish that Conklin was disabled from timely complying.  The Willetts’ allegations do not suggest that their agent’s misbehavior was remotely comparable to the controller’s misconduct in Conklin.

(emphasis added; citations omitted)

Conclusion

Willett is a reminder that Boyle generally will prevent a reliance defense in the context of missing a return filing deadline. While there are grounds to challenge Boyle in the context of e-filing (as we have discussed before), Boyle casts a long shadow over taxpayers seeking to escape the hefty civil penalties for late filing. While the Willetts were mightily inconvenienced by their preparer’s failure to prepare the returns and the absence of their K-1s, W-2s and 1099s, the circumstances did not excuse the tardy filing.

As Willett demonstrates, the responsibility to file rests on the taxpayer. One of the barriers that the Willetts faced was that their old preparer had their tax information returns. To be sure the government could make it easier for taxpayers to comply by, for example, seamlessly providing taxpayers access to all information returns they receive from third parties. Last summer, I signed up for an online tax account from the IRS-one of its virtues is that by the time I got around to filing last October I was able to see in one spot the information returns that the IRS had on record for my 2018 year. Of course, most financial institutions and many employers provide access to the information returns if a taxpayer no longer has the original. At some point I suspect that the IRS will make a central portal more readily available for all taxpayers, thereby reducing the burdens of compiling (or retrieving) the returns that are necessary to file.

Graev and the Trust Fund Recovery Penalty

The Tax Court is marching through the penalty provisions to address how Graev impacts each one.  It had the opportunity to address the trust fund recovery penalty (TFRP) previously but passed on the chance.  In Chadwick v. Commissioner, 154 T.C. No. 5 (2020) the Tax Court decides that IRC 6751(b) does apply to TFRP and that the supervisor must approve the penalty prior to sending Letter 1153.  Having spoiled the ending to the story, I will describe how the court reached this result. See this post by Bryan Camp for the facts of the case and further analysis.

This is another decided case with a pro se petitioner, in which the petitioner essentially dropped out and offered the court very little, if any, assistance.  The number of precedential cases decided with no assistance from the petitioner continues to bother me.  I do not suggest that the Tax Court does a bad job in deciding the case or seeks to disadvantage the taxpayer, but, without thoughtful advocacy in so many cases that the court decides on important issues, all taxpayers are disadvantaged — and not just the taxpayer before the court.  Clinics and pro bono lawyers have greatly increased the number of represented petitioners in the Tax Court over the past two decades, but many petitioners remain unrepresented. These unrepresented petitioners, by and large, do not know how to evaluate their cases and how to represent themselves, which causes the court to write opinions in a fair number of pro se cases relying on the brief of the IRS and the research of the judge’s clerk in creating a precedential opinion.  Should there be a way to find an amicus brief when the court has an issue of first impression, so that subsequent litigants do not suffer because the first party to the issue went forward unrepresented?

read more...

The real question here is whether the TFRP is a tax or a penalty.  The IRS argues that IRC 6751(b) does not apply to the TFRP because it is a tax.  We know it’s a tax because the Supreme Court has told us so in Sotelo v. United States, 436 U.S. 268, 279 n.12 (1978).  In Sotelo the Supreme Court sought to characterize the TFRP for purposes of bankruptcy.  In bankruptcy getting characterized as a penalty has very negative consequences with respect to priority classification, discharge and even chapter 7 priority of secured claims.  We have written about several code sections that bankruptcy courts have characterized from tax to penalty or vice versa based on the Supreme Court’s analysis in Sotelo.  You can find a couple of those posts here, and here

So, if TFRP acts as a tax for purposes of bankruptcy, should it, could it act as a penalty for purposes of 6751(b)?  While the Tax Court had skirted the issue previously, the Southern District of New York had decided it head on in United States v. Rozbruch, 28 F. Supp. 3d 256 (2014), aff’d on other grounds, 621 F. App’x 77 (2nd Cir. 2015).  In Rozbruch the court held the TFRP a tax that did not require penalty approval under IRC 6751(b).

The TFRP does not seem like the kind of penalty Congress intended when it worried about using penalties as a bargain chip.  The TFRP is the chip.  It imposes on the responsible person or persons the unpaid tax liability of the taxpayer charged with collecting taxes on behalf of the United States, who failed to fulfill that responsibility.  Good reasons exist not to apply IRC 6751(b) in the TFRP context.  The reasons could have made for another contentious Tax Court conference in the Graev Conference Room, but no one at the court seemed up for the fight.

Instead, the Tax Court settles for a straightforward determination that Congress put the TFRP in the penalty sections of the code, Congress called the TFRP a penalty, and it has some features of a penalty to support its label as a penalty.  While acknowledging that the Supreme Court has held that for bankruptcy purposes TFRP will act as a tax, the Tax Court says that does not mean it isn’t a penalty, citing the wilfullness element necessary to impose the TFRP.  It also finds that the assessable feature of the TFRP supports the penalty label.  So, without a decent fight between Tax Court judges, we get the result that the Tax Court finds the TFRP to be a penalty.  This fight may not be over if the IRS wants to bring it up again.  Unlike lots of liabilities that primarily if not exclusively get decided in Tax Court, matters involving the TFRP primarily get decided in district courts.  Only in the CDP context will the Tax Court see a TFRP case.  So, this may not be the end of road for this issue.

Having decided that the TFRP is a penalty, the Tax Court then decided when the “initial determination” occurred.  Relying on its recent opinion in Belair Woods LLC v. Commissioner, 154 T.C. 1 (2020), the Tax Court decided that the initial determination of the penalty assessment was the letter sent by the IRS to formally notify the taxpayer that it had completed its work.  In the TFRP context this is Letter 1153.  Here the IRS had obtained the right approval prior to the sending of this letter and the court upheld the TFRP.

The Court reaches a taxpayer-friendly conclusion that the IRS must obtain supervisory approval prior to the application of this unusual provision and perhaps did not find any judges putting up a fight against that result because it was taxpayer-friendly.  As with most 6751 decisions, it’s hard to say what Congress really wanted in this situations.  The result here does not bother me.  Certainly, the result has logical support, but the opposite result would have logical support as well.  It will be interesting to see if the IRS wants to fight about this further in the district courts or if it will just acquiesce.  At the least the IRS will want to cover its bases by timely giving the approval, even if it thinks the approval is unnecessary.  The first time a large TFRP penalty gets challenged and the approval was not timely given, the IRS will have to swallow hard before giving up the argument entirely.

Graev and the Reportable Transaction Penalty

In Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner, 154 T.C. No. 4 (2020) the Tax Court addresses the need for supervisory approval and the necessary timing of supervisory approval when the IRS imposes the reportable transaction penalty under IRC 6707A.  We will discuss the mechanics of the penalty below, but this is a really harsh penalty and setting the scene deserves some attention.  When I say harsh, I do not mean to imply that the penalty should not exist or that the IRS improperly imposed it here or elsewhere.  The harshness of this penalty derives from the amount of the possible penalty.  We discussed this penalty in the context of the Flora rule in the case of Larson v. United States where the IRS assessed a penalty of about $163 million against Mr. Larson and others for failing to disclose a reportable transaction.  See the discussion of Larson here and here.  So, the ability of 6751(b) to provide a basis for removing this penalty if the IRS failed to follow the proper procedures for supervisory approval could make a huge dollar difference to certain taxpayers.

The Laidlaw case also deserves attention for the procedural posture of the case at the time the Court makes its decision here.  Note that petitioner filed this case in the Tax Court in 2014 and that the tax year at issue is fiscal year 2008.  Remember that in 2008 no one paid attention to IRC 6751(b).  The issue comes up here in the context of Collection Due Process (CDP) many years after the IRS made the assessment.  The IRS must verify the correctness of its assessment in the CDP process.  Here, the CDP process offers the taxpayer the opportunity to raise an issue and obtain court review it otherwise would not have.  How many other penalties assessed long ago before anyone paid attention to IRC 6751(b) might CDP prove as the place where penalties go to die?  Since Graev brought 6751 to everyone’s attention, the number of times the IRS will fail to get the appropriate supervisory approval will be quite low; however, many penalties exist on the books of the IRS from 10 years ago that were imposed at a time when the IRS did not pay careful attention to the supervisory approval rule or have court guidance on when the approval must occur.  Taxpayers with old penalties who might pay those penalties should make certain to raise the supervisory approval issue through CDP, audit reconsideration or whatever procedural avenues remain open.

read more...

Laidlaw participated in a listed transaction and did not disclose that participation on its tax return.  Subsequent to filing its return for fiscal year 2008, Laidlaw did send to the IRS Form 8886 amending its return and reporting the participation.  A revenue agent examined Laidlaw’s 2008 return and concluded that because it did not include the reportable transaction on the original return, the 6707A penalty applied.  The revenue agent made the initial determination as that phrase is used in 6751 by sending a 30-day letter.  This letter did not contain the approval of the revenue agent’s supervisor.  A month after sending the 30-day letter the revenue agent’s supervisor did approve the assertion of the 6707A penalty.

Laidlaw appealed the assertion of the penalty.  After only two years, Appeals sustained the decision to impose the penalty leading to an assessment of the penalty in 2013.  The penalty was assessed in mid-September, and the notice of intent to levy was sent in mid-November.  The short period of time between the assessment and the notice of intent to levy shows the difference in the way the IRS treats assessments against entities compared to individuals, where the time period between assessment and the notice of intent to levy would have been two or three months longer, because the notice stream for individuals is four letters instead of two. 

Upon receiving the notice of intent to levy, the IRC 6330 notice, Laidlaw timely requested a CDP hearing.  In the CDP hearing the Appeals employee notified Laidlaw that it could not challenge the merits of the 6707A penalty because it had an opportunity to do so administratively by going to Appeals before the assessment of the penalty.  (Read the Larson case above or the discussion of CDP cases tried by Lavar Taylor if you want to know more about the inability to litigate the large penalties imposed under 6707A.)  The Appeals employee did not verify that the supervisor had properly approved the penalty.  Of course, at the time of the verification process in this case, the timing of the supervisory approval did not enter the minds of many people inside or outside of Appeals.  What’s important here is that, even though the right to a merits review of the 6707A did not exist, that right exists separately from the obligation under IRC 6330(c)(1) of the Appeals employee to verify the correctness of the assessment.  The verification requirement serves here as a powerful remedy for the taxpayer.

The IRS argued in this case that the supervisory approval did not need to come before the issuance of the 30-day notice but only before the making of the assessment.  No need to go into the tortured language of 6751 and why the IRS or anyone might question the timing of the assessment for those who regularly read this blog.  For anyone wondering why the IRS would not immediately concede the issue, put Graev into the search box of the blog and read the myriad opinions on 6751 trying to parse its meaning.

While the IRS argument might have merit, the Laidlaw case follows the decisions in Clay and in Belair (see discussion of that case here) in which the Tax Court seeks to finally create a bright line for when approval must occur.  Laidlaw seeks to apply that same bright line test to 6707A.  In applying that bright line, Laidlaw looks to the first formal pronunciation by the IRS of the desire to impose the penalty.  That bright line occurs with the sending of the 30-day letter.  At the time the IRS sent that letter it lacked the approval of the revenue agent’s immediate supervisor.  Therefore, the penalty here fails.

Ringing in the New Year with Another Graev Case

On January 7, 2020, the Tax Court issued a TC opinion in Frost v. Commissioner, 154 T.C. No. 2 (2020).  This case presents another permutation of the issues raised in Graev and is another case decided on this issue in which petitioner handled the case pro se, although Mr. Frost has been an enrolled agent for 25 years.  The opinion says that before he became an enrolled agent he performed collections work as an IRS revenue agent.  He would have been a most unusual revenue agent if he performed collection work, so I assume that he was a revenue officer.  Whether he was a revenue officer or revenue agent, working five years or more for the IRS in either position can chart a path to receiving the enrolled agent designation without taking the difficult test to become an enrolled agent. This background indicates that he was not the usual pro se taxpayer though he may have lacked experience in the Tax Court.  His knowledge of the tax system comes back to haunt him in the end.

read more...

The underlying issues in the case concern business expenses and a loss reported on an LLC in which he had a controlling interest.  Though we do not care about his underlying tax issues, the court obviously must and it goes through the case and statutory law governing the proper deduction of business expenses, before arriving at the conclusion that, despite his extensive and long-standing experience preparing tax returns, petitioner failed to present any evidence in support of his expenses and failed to comply with the strict substantiation requirements of IRC 274(d).  He sounds very much like many clients of the tax clinic. 

Similarly, with respect to the loss claimed from his LLC, his failure to establish his adjusted basis torpedoed his chances of winning this issue.  It’s hard to know with proof issues whether his failure was one of lack of understanding the necessary information he needed to place before the court (or the IRS during the administrative phase) or simply the claiming of tax benefits he was never entitled to in the first place.

He made arguments about the notice of deficiency and why he was selected for audit.  I imagine he pointed out there were many taxpayers more deserving of being audited than him, etc., etc.  The court disposed of this argument citing Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324 (1974) and a few of the other from thousands of cases it could have chosen to knock down this cry for help based on perceived fairness issues.

Now, the court gets to the meat of the case for our purposes and looks at the penalties imposed upon him.  It points out that the IRS bears the burden of production with respect to the penalties, which requires the IRS to come forward with sufficient evidence showing the appropriateness of imposing the penalties.  This includes showing that IRC 6751(b) compliance occurred.  The court walks through the various burdens on the IRS when taxpayer challenges penalties the IRS proposes to impose and discusses the requirements of IRC 7491(c).  It then turns to 6751(b) and notes that here the IRS “produced no evidence of written supervisory approval of the initial determination of section 6662(a) accuracy-related penalties for 2010 and 2011.”  I am a bit confused why the IRS did not concede this issue if it had nothing to show approval of the penalties for these two years.

It’s a different story for 2012.  The IRS does have a signed penalty approval form signed by the revenue agent’s immediate supervisor over a year before the issuance of the notice of deficiency.  The court finds that the introduction by the IRS of the approval form signed before the notice of deficiency satisfies the burden of production on the IRS.  The burden then shifts to petitioner to show evidence suggesting that the approval was untimely.  The court notes in footnote 6 that in Graev it reserved “the issue of whether the Commissioner bears the burden of proof in addition to the burden of production.  We reserve that issue here as well because placement of the burden of proof here… would not change the outcome.  Here, Mr. Frost came forward with no evidence to contradict the supervisory approval for 2012.

Mr. Frost did not claim or put on any evidence that the formal notice of the imposition of the penalty preceded the approval of the penalty.  So, the court turned to the balance of the burden on the IRS as established in Higbee v. Commissioner, 116 T.C. 438 (2001).  This burden requires showing that the penalty should apply in this situation.  Here the IRS showed that the understatement of tax by Mr. Frost exceeded $5,000 and that the IRS correctly calculated the penalty based on the understatement.  It was then up to Mr. Frost to show that he had reasonable cause for the underpayment.  Mr. Frost put on evidence of his brother-in-law’s health issues during the year at issue, but he has the problem that he has lots of tax experience.  The court expects more from him than it would expect from someone who had not been working in the tax system for 40 years and finds his excuses inadequate to meet his burden of showing reasonable cause and good faith.

Frost does not break as much new ground as some of the other recent TC opinions on 6751 but it does do a nice job of laying out what the court expects of each party when they engage in penalty litigation.  I don’t know why the IRS was holding on to 2010 and 2011 as penalty years if it lacked the managerial approval.  Surely, by this time it knew that it must have the approval or fail.  The docket number is from 2015 so perhaps at the time this case was submitted a few years ago, the Graev case had not become clear.  That’s my guess.  When it takes close to five years between the time a case starts until it reaches opinion, intervening legal opinions can change what the IRS might have argued when the case started.

Imposing the Frivolous Return Penalty

At the end of last summer, the Tax Court issued a TC opinion on the issue of imposing the frivolous return penalty of IRC 6702.  In that opinion it also discussed, inevitably, the impact of Graev on this particular penalty.  We should have covered this case closer to the time it came out.  Several subsequent opinions have cited to it.  This post seeks to correct the omission and make you all aware of Kestin v. Commissioner, 153 T.C. No. 2 (2019).

This case provides yet another example of how friendly the Tax Court is to petitioners.  Of course, statistically, the Tax Court rules most of the time for the IRS; however, it generally gives the taxpayers ample opportunities to make their case.  Mrs. Kestin did not appear for the trial of her case but that did not stop the court allowing her to participate in post-trial briefing and for holding, in part, in her favor despite the position she took on her amended return.

read more...

Mrs. Kestin got off to a good start, from a tax perspective, in 2014.  She timely filed a joint return with her husband reporting her wages of over $155,000 from which she was withheld.  Something happened there after that caused her to lose faith with the tax system.  In September 2015 she submitted an amended return which the Tax Court describes as frivolous and which the IRS identified as frivolous for purpose of imposing the IRC 6702 penalty.  The amended return reported a zero liability accompanied by a narrative that I would describe as tax protestor language, together with a request for a refund of all of the money withheld from her in 2014.

The IRS sent her correspondence pointing out that her amended return could result in the imposition of the IRC 6702 penalty and giving her a chance to avoid the penalty by correcting the frivolous filing.  Unfortunately, she doubled down on her newfound position by sending a letter pointing out the IRS was wrong and attaching a copy of the original amended return.  She did not stop there but sent five more letters to the IRS explaining her position, each one attaching a copy of the amended return.  The IRS imposed a new penalty assessment each time it received one of her missives.

To assist in collecting the sizable liability resulting from the imposition of all of these $5,000 penalties, the IRS filed a notice of federal tax lien and that provided her with the opportunity to request a Collection Due Process (CDP) hearing which she did.  In the CDP hearing she sought, inter alia, to contest the imposition of the penalty on the merits.  Faithful readers know it is hard to raise merits issues regarding assessable penalties because taxpayers have typically had a prior opportunity to go to Appeals before the imposition of the assessable penalty at issue; however, Appeals will not hear frivolous arguments, so she got to raise the merits in her CDP case.

The court imposed the 6702 penalty on the original filing of the amended return and says that Mrs. Kestin agrees with that penalty except for some procedural differences.  The focus then turns to the six times she mailed a copy of the frivolous return to the IRS and it imposed additional penalties.  In a 6702 case, the issue is not what is a return – as the court has discussed many times going back to the Beard case – but what purports to be a return.  When she mailed in the additional six documents she marked them as copies.  The court found that because these documents were marked as copies they did not purport to be returns.  The court points out that the statute does not address whether copies might trigger the penalty and neither do the regulations or prior case law.  On the facts here, it holds that the six copies she sent in her follow up correspondence did not purport to be returns and cannot form the basis for imposition of the penalty.  While the decision is important, and certainly important for Mrs. Kestin, the fact pattern here may be a narrow one although a couple of subsequent opinions discussed below may suggest otherwise.

Having removed all but one of the penalties based on the lack of the filing of documents purporting to be a return, the court then moved to the now inevitable inquiry concerning supervisory approval.  The IRS conceded that the penalty here was not calculated by electronic means and required supervisory approval.  Next, the court turned to Letter 3176C sent by the IRS to Mrs. Kestin warning her that if she did not correct the amended return asserting the frivolous position, the IRS intended to impose the 6702 penalty.  Was this letter the “initial determination” of the penalty that required supervisory approval prior to mailing?  The court finds that the sending of this letter did not mark an initial determination because at the time of sending this letter it remained to be seen whether the penalty would apply.

After acknowledging the strange language of the statute that does not fit the situation, the court found this letter served to warn the taxpayer rather than to determine the penalty liability.  Because it gave the taxpayer the opportunity to avoid the penalty by correcting the submission, the initial determination could not occur until after the proffered period of retraction.  The actions of the IRS did not seek to use the letter as a bargaining chip but rather as an opportunity to avoid imposition.  Kestin is one of several cases decided in the past few months on the issue of initial determination including the severely split decision in Belair Woods, LLC v. Commissioner, 154 T.C. No. 1 (2020) (though Judge Gustafson dissents in Belair Woods after penning Kestin because he perceives a distinction between the situations.)  The decision here appears generally consistent with the other decisions and in some respects foreshadows their outcome.

In the short time since the Kestin opinion the Tax Court has had several additional opportunities to address the issue of frivolous penalties and taxpayer submissions.  In Smith, the taxpayer sent an objectionable original return.  She sent at least one copy of that return with later correspondence (can’t tell yet how many).  Her case was tried (without her showing up) and post-trial briefs were filed. Then, both Graev III and Kestin came down.  In an order from August 30, 2019, Judge Halpern invited additional briefing from the parties by mid-September concerning the application of both opinions.  Only the pro se taxpayer filed a supplemental brief.  The case is awaiting decision, which may be further held up pending the Kestin appeal (see discussion below.)  In Luniw, a bench opinion from Judge Carluzzo served Nov. 20, 2019, the taxpayer was hit with three 6702 penalties.  One was for his original return.  Then the IRS wrote back proposed changes to the return causing the taxpayer to generate essentially the same return and sent it again to the IRS.  Later the taxpayer sent a second copy of the return to the IRS.  Judge Carluzzo applies Kestin and holds that only the last document is not subject to a penalty. Finally, in Jaxtheimer, the taxpayer filed his 2013 return three separate times, reporting zero wages and zero tax owed. Upon each instance, the IRS assessed 6702 penalties. Judge Pugh upheld only the first instance of the penalty assessment, citing Kestin and finding that there was insufficient evidence to determine that the two later-filed returns were not copies.

Mrs. Kestin raised a few other issues which the court brushed away with relatively little fanfare.  The most important of these lesser issues concerns the adequacy of the notice of determination.  She argues that the notice fails because it describes two occasions of frivolous action when the IRS sought to impose seven penalties.  Citing to its earlier opinion in First Rock Baptist Church Child Dev. Ctr. v. Commissioner, 148 T.C. 380, 387 (2017), blogged here, the court holds that if the notice contains enough information to allow the taxpayer to understand the matter at issue and does not mislead it satisfies the statutory requirement.

We blogged about the Kestin case prior to its decision here, here, and here.  This may not be the last time we blog about it.  The IRS filed a notice of appeal in the 4th Circuit on Wednesday, January 8.  I am mildly surprised that it is appealing this case because the circumstances seem pretty narrow; however, the three subsequent opinions citing to Kestin suggest my view of the universe of frivolous cases may just be too limited.  From the perspective of the IRS, the amount of effort to handle a copy of a frivolous document probably closely equals the amount of time it takes to handle a document that purports to be a return.  So, it may want to argue that the decision does not follow the intent of the statute.  It seems like it could get where it wants to go with a regulation, but I do not know what drives this decision.  To my knowledge Mrs. Kestin continues to pursue this matter pro se.  If anyone has a significant interest in the issue and feels the Tax Court got it right, perhaps an amicus brief would be of assistance to her.

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.

read more...

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.

read more...

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

read more...

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.