Honest Mistakes Happen, But a Two Million Dollar Difference in Mortgage Interest Will Likely Trigger An Accuracy-Related Penalty

Busch v Commissioner, a small tax case issued as a bench opinion, involves a couple who claimed to have made an honest mistake on their self-prepared tax return.  According to the Busches, when using their tax return prep software, the software did not allow them to enter cents when recording the mortgage interest paid in a year. The Busches paid $21,201.25 in deductible mortgage interest and entered $21,201.25 line for their mortgage interest, but the software, kicking out the cents, recorded the deduction as $2,120,125 instead. The couple of million dollar difference led IRS to likely discover the error automatically via document matching.

What followed was likely mismatch virtual audit, a notice of deficiency that adjusted for the underpaid tax, and for good measure, a proposed 20 per cent substantial understatement accuracy related penalty under Section 6662(a). The Busches filed a petition, conceding the extra tax but challenging the penalty.

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The issue in the case was whether the taxpayers could establish that they acted with reasonable cause and in good faith under Section 6664(c) and thus be excused from the penalty.

The brief opinion notes that the taxpayers urged the court to find that the error was an “honest” mistake, and, as such, they should not be penalized for that mistake. The opinion shows some sympathy for the taxpayers and more generally to how it is possible that taxpayers may foot fault when using software:

[The taxpayers] ask the Court to recognize, as they point out that honest mistakes are sometimes made. As a general proposition of life, we agree with petitioners on the point, and we further agree with petitioners’ suggestion that not every mistake made on a Federal income tax return should result in the imposition of an accuracy-related penalty. A person preparing a return might understandably get distracted while doing so and enter the wrong amount for an item, or if not distracted, when transferring numbers from one document to another, transpositions often occur. If a computer-based software program is being used in the process, the limitations and requirements of a software program might not be fully appreciated by the user. Any number of situations could cause an “honest” mistake to be made when amounts are incorrectly reported on a Federal income tax return. 

The problem with the taxpayers’ argument though was that the taxpayers had an obligation to review the return. The two-million dollar difference between the deduction on the return and interest actually paid should have triggered greater inquiry into the matter:

But petitioners’ focus on the erroneous entry as the “mistake”, and their explanation describing how the mistake occurred, misses the point. The mistaken entry is not the real problem. Their mistake was failing to review the return carefully enough to have recognized the erroneous entry before the return was filed. After all, it should go without saying, that a taxpayer’s obligation to prepare and file a Federal income tax return includes the duty to review that return to ensure that the information reported or shown on the return is accurate before the return is filed.

The opinion notes that the “deduction for mortgage interest shown on the return occupies at least two additional columns” on the same page as where the deduction appears on the return:

Looking up and down the columns showing other items reported on the return, the mortgage interest deduction sticks out, as the saying goes, “like a sore thumb”. A careful review of the return after it was prepared would most certainly have caught the error; actually, even as little as a quick glance at the return probably would have done so.

Conclusion

This is another in the line of cases that holds that the use of tax software by itself is not sufficient to establish a defense to an accuracy-related penalty. As Bryan Camp noted in Lesson From The Tax Court: The Turbo-Tax Defense in Tax Prof a few years ago, there is dicta in a Tax Court opinion that suggests that the use of software can help establish reasonable cause/good faith. But hiding behind “the software made me do it” is not enough to insulate all taxpayers from penalties.

To succeed in blaming the software, taxpayers will generally achieve better results if the software issue involves a question of the proper tax treatment of the item as opposed to a clerical type mistake any taxpayer could pick up by reviewing the return.  The taxpayers discussed in post by Bryan Camp were sophisticated yet the Tax Court, in dicta, expressed sympathy with their plight.  Similarly, former Treasury Secretary Timothy Geithner had a problem reporting his income from the World Bank that he blamed on the tax prep program.  His excuse worked to get him out of a confirmation pickle.  Where the defense of the computer made me do it fails is in cases in which any reasonable taxpayer should recognize the mistake if they took care.

Taxpayers can generally rely on a paid preparer to insulate them from the penalty when taxpayers give the paid preparer all of the information necessary and the preparer makes a mistake; however, just having a paid preparer doesn’t necessarily insulate a taxpayer from the duty to review the return and catch obvious mistakes.  Taxpayers could not easily escape penalty where a return contained an obvious mistake just by saying they relied on the accountant to add the numbers properly and if the accountant said 1 + 1 + 3 the taxpayer had no duty to correct the mistake. 

Courts seek to build on decades of case law involving human paid preparers as they analyze situations in order to decide the appropriateness of penalizing someone relying on digital paid preparers.  Taxpayers choosing the do it yourself route can put some blame on their digital preparer but must assume some responsibility to check to make sure the resulting return makes sense.  Had the taxpayers here checked, they would have concluded the return did not reflect the correct tax result.  The Busches bore responsibility to at least check for a return that made sense.

No Reasonable Cause When Tax Return Preparer Fails to E-file Extension

A recent district court opinion addresses the inability to establish reasonable cause for a late filing penalty even if a longtime preparer promised but failed to e-file an extension of time to file a 1040.  The case, Oosterwijk v United States, brings in interesting reasonable cause issues and highlights the limits of the IRS First Time Penalty Abatement policy.

In 2017, taxpayers Erik and Aspasia Oosterwijk sold for many millions of dollars a Baltimore based wholesale meat business that they had run for decades. When it came time to file their 2017 tax return on Tuesday April 17, 2018 (Monday April 16, 2018 was Emancipation Day in DC), the taxpayers expected their longtime preparer to e-file an extension and instruct IRS to apply a payment of about $1.8 million in taxes.  The taxpayers made sure they transferred money to their checking account, and kept looking to see when the tax payment would hit the account.

By April 25, when the money was still not debited from their account, the taxpayers emailed their longtime CPA tax return preparer, who told them to wait until April 30, and if the money were still in their checking account at that date he would follow up with the IRS.

On April 29 the now concerned taxpayers emailed their CPA again saying that the money was still in their account. The preparer checked his records and……

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You guessed it. The preparer realized that that he failed to e-file the extension and had not given instructions to IRS to debit the payment.

What happens next compounds the original problem.

The preparer advised the Oosterwijks that if they immediately filed a six-month Extension Request on Form 4868, they would have until October 15, 2018, to file their tax return, and the penalties for late filing would stop accruing..
The taxpayers followed the advice and immediately mailed in the Form 4868 and a check for $1.8 million, which IRS processed on May 4, 2018.

On June 29, 2018 the Oosterwijks’ CPA e-filed their 2017 return. Upon processing the return, IRS assessed failure to pay penalties of about $8,860 for the one month non payment delinquency period that ran April 17 to May 4, 2018. IRS assessed failure to file (FTF) penalties of about $259,000 for the three month late filing period that ran from April 17 to June 29th 2018, the date that Oosterwijks’ CPA e-filed their return on their behalf.

The Oosterwijks (and their CPA) were surprised that the IRS assessed a FTF penalty for the two-month period that ran from May 15 to June 29th. Based on their CPA’s advice, the taxpayers had incorrectly believed that by paying their taxes, submitting the Extension Request on May 4 (during the first month), and filing the return before October 15, they would halt the accrual of any FTF penalties beyond the first monthly delinquency.
Well, as you likely know, the CPA and his clients were mistaken. A late filed extension to file does not excuse FTF penalties for any subsequent filing.

In November 2018, after the IRS assessed both delinquency penalties, the taxpayers’ CPA requested penalty relief based on reasonable cause. The IRS denied the relief, and the CPA appealed administratively on behalf of his clients. The Appeals Officer agreed to abate about 50% of both delinquency penalties.
Despite the 50% abatement, the taxpayers were not happy with the result. By March of 2019, the taxpayers sent in another letter to IRS stating that they believed they should be relieved of all the penalties, raising the issue of their reasonable cause for late filing due to their CPA’s failure to e-file the extension and his incorrect substantive advice about how to halt the FTF penalty’s accrual.

IRS did not respond, and the taxpayers paid the balance due and filed a refund claim. After six months passed they then filed a refund suit in federal district court, claiming that they had reasonable cause for the delinquency due to both the mistaken belief that the extension were filed and the reliance on substantive advice that a late filed extension excused a portion of the FTF penalties.

Following the complaint, the government filed a motion to dismiss, which the court treated as a motion for summary judgment.

As a threshold matter, why didn’t the taxpayers avoid having to file a suit and request administrative relief under the IRS’s First Time Abatement policy? To add insult to injury the Oosterwijks were not eligible, because their decades long history of tax compliance was tainted by a $7 late payment penalty from the 2014 tax year and the first time abatement for delinquency penalties requires a clean past three years of tax compliance.

With that out of the way the opinion first addressed a variance issue because the formal refund claim addressed reasonable cause relating to the mistaken belief that the extension was filed and did not mention the advice the CPA gave about limiting penalty accrual by filing a 4868 after the due date of the return. The opinion concluded that the claim and communications with IRS were sufficient to put IRS on notice about the full extent of the reasonable cause argument. (as an aside the opinion also seems to mix up the SOL issues in 6511 and 6532).

That gets to the merits of the reasonable cause defense. The taxpayers argued that the FTF penalties should be completely excused because they had reasonable cause for filing late, specifically that their accountant failed to e-file their extension request and their personal e-filing access was limited.

Boyle and Non Delegable Duties

This of course brings in the Boyle case and its applicability to failures to e-file, which we have discussed in Delinquency Penalties: Boyle in the Age of E-Filing and more recently in Possible Opening in Defending Against Late Filing Penalty When Preparer Fails to E-file Timely. To date, even when a taxpayer is relying on an agent to e-file, courts have been unwilling to distinguish Boyle and have held that reliance on a third party to file a return does not establish reasonable cause because “[i]t requires no special training or effort to ascertain a deadline and make sure that it is met.”

The Oosterwijk opinion cites to the opinion in Boyle, and also to Justice Brennan’s concurring opinion, where he “stressed that the ‘ordinary business care and prudence’ standard applies only to the “ordinary person.” That is, the standard exempts individuals with disabilities or infirmities that render them physically or mentally incapable of knowing, remembering, and complying with a filing deadline.”

The Oosterwijks argued that “Boyle does not apply to electronic filing, because a taxpayer cannot personally confirm that an accountant has e-filed as promised.”

The Oosterwijks essentially argued that the placement of a third party (the preparer) “between the taxpayer and the IRS, and the Oosterwijks’ inability either to e-file on their own or to confirm the e-filing’s transmission put the filing beyond their control according to Justice Brennan’s concurrence.”

The opinion disagreed, noting that the taxpayers were free to paper file an extension (and in fact did so):

The specialized technology and professionals-only availability of e-filing need not have been a barrier to the filing of an Extension Request; the same means available to the Boyle taxpayer in 1979 were available to the Oosterwijks in 2017, even if the IRS encourages e-filing.

Moreover, the opinion notes that Justice Brennan’s Boyle concurrence “contemplates differently abled taxpayers who are physically or mentally incapable of meeting filing deadline. The Oosterwijks do not fall under this exception.”

What About The CPA’s Substantive Advice?

Boyle does not prevent a finding of reasonable cause when a taxpayer’s non or late filing was due to erroneous substantive legal advice as compared to just an agent’s failure to file a return or extension. To that end, the Oosterwijks argued that the penalty period after the first month should be excused because their preparer mistakenly believed and advised them that if they mailed an extension after the due date of the return so long as they paid any balance due and filed the 2017 return by October 15, 2018 they would only be subjected to one-month FTF penalty. This, they argued, amounted to substantive legal advice.

A. Is The Penalty Divisible

As I mentioned above, that advice was wrong; the FTF penalty is based on the net tax due as of the due date of the return, and the delinquent extension provided no benefit. But should the taxpayer be expected to second-guess their preparer?

The court’s inquiry focused on timing. Does it matter if the substantive advice arises after the due date of the return? The opinion notes that the reasonable cause inquiry looks to the due date, and while the due date (and thus inquiry time) could be extended if the taxpayer timely filed an extension, actions beyond the due date are not determinative.

To be sure, the opinion notes that reasonable cause at the due date does not mean that there is reasonable cause for the entire delinquency period, citing to the Federal Circuit Court of Appeals case from 2013, Estate of Liftin v US.

The government argued that any advice that the Oosterwijks’ preparer gave after the April 17 due date was irrelevant if as of the original due date the taxpayer did not establish that it had reasonable cause (and as discussed above there was no reasonable cause as of April 17).

The taxpayers essentially argued that the FTF penalty was divisible, or that whether a taxpayer has reasonable cause should be evaluated on a monthly basis given that the penalty amount is triggered by each monthly delinquency period:

To the Oosterwijks, the core issue is whether reasonable cause arose as to parts of the penalty incurred in later months when, after the deadline had already passed, they relied on their tax professional’s bad substantive advice about what actions would stop the accrual of a tax penalty. They say that this would leave intact the April 2018 penalty but would require removal of the penalties for May and June 2018, the months after [the CPA’s] incorrect April 30 advice. The Oosterwijks focus on the distinction between relying on a tax professional to perform the ministerial (and non-delegable, under Boyle) duty of filing an extension return, as compared to the tax professional’s erroneous substantive advice about what actions would halt the penalty’s accrual.

On divisibility, the court examined case law which suggested that the FTF penalty was divisible but distinguished those circumstances. Those cases mostly involved erroneous “legal advice about the availability of second extensions after the taxpayer had already timely filed and obtained a first extension.”

In those cases there was reasonable cause at the original due date but not later:

These second-extension cases are distinct from the Oosterwijks’. The taxpayers in these cases were erroneously advised by their attorneys before their (first extended) deadlines had passed, meaning they could still have had reasonable cause under § 6651. The fact that they received erroneous advice after their original deadlines is immaterial, because their reasonable cause evaluation was governed by their first extended deadline. In contrast, the Oosterwijks received their erroneous advice after the deadline had passed and therefore after the door had closed on reasonable cause for late filing.

Similarly, the opinion distinguished Estate of Liftin, where a taxpayer had reasonable cause at the date of filing based on erroneous advice about not needing  to file an estate tax return until after the taxpayer’s spouse had become a citizen.  In Liftin, the reasonable cause defense did not apply to the FTF penalty when circumstances changed and the spouse became a citizen, but there was still an additional 9-month delinquency prior to filing:

Liftin shows that although the penalty is not entirely indivisible for the purposes of the reasonable cause exception, it is not divisible in the way the Oosterwijks hope. They, unlike the Liftin taxpayer, failed to meet the initial requirements of reasonable cause. The purpose of encouraging timely filing is best served by reading the statute to allow reasonable cause to expire based on a change in circumstances at some point in the delinquency but not allowing it to materialize where the taxpayer had none at the time of filing.

B. Even if the Penalty Were Divisible the Advice Was Not Reasonable

For good measure, the opinion notes that even if the penalty were divisible in the way the Oostwerwijks argued they still would not qualify for relief because the advice they received was not reasonable given the explicit text of Form 4868. In so concluding the opinion cites to Baer v US, a 2020 Court of Federal Claims opinion that considered a CPA’s failure to file a 4868 because he believed that any extension had to be accompanied by a taxpayer payment. While Baer held that the CPA’s actions were not advice and thus could not justify a taxpayer’s reliance, it also held that if it did amount to advice it was not based on a “reasonable factual or legal assumption.” That was because the text of the extension form directly contradicted the CPA’s mistaken belief, that it could not file a 4868 a scenario analogous to the Oosterwijk’s situation where the form itself stated that the taxpayer must file the 4868 by the due date to receive the extension.

In contrast in La Meres v Commissioner, one case where a taxpayer was able to establish that mistaken advice as to an extension was reasonable cause, the opinion notes that the advice concerned the advisor’s mistaken belief that the taxpayer was entitled to two extensions of time to file an estate tax return, an issue not addressed in the form itself but only  “toward the end of the relevant estate tax regulation” and one in which the IRS actions misled the taxpayer into thinking a second extension was valid.

Concluding Thoughts

The court signs off by acknowledging that it is “sympathetic to the Oosterwijks, who were not willfully neglectful but rather appear to have relied on the advice of a trusted professional, intending to fulfill their obligations under the tax laws.”

Yet the court also acknowledges that the government was not at fault and did in fact abate about half of the penalties. 

I am not sure I accept that there is no government fault here.  Even though I suspect the taxpayers’ longtime preparer will likely reimburse the taxpayers in light of a possible malpractice suit (though maybe Congress should consider directly penalizing the preparer rather than forcing the taxpayer to seek reimbursement from the preparer), the case leaves a bad taste in my mouth.

Apart from my belief that courts (and the IRS) should distinguish Boyle when e-filing makes it difficult to monitor an agent’s actions, the policy underlying the imposition of civil penalties and the first time abatement policy itself suggest that the IRS should have exercised discretion and abated the FTF penalty in full.

Recall that the taxpayers had a long history of tax compliance, save for a 2014 $7 delinquency penalty. Under the First Time Abatement policy, the IRS will abate a delinquency penalty if a taxpayer

  • Didn’t previously have to file a return or have no penalties for the 3 tax years prior to the tax year in which the taxpayer received a penalty;
  • Filed all currently required returns or filed an extension of time to file; and
  • Has paid, or arranged to pay, any tax due.

As the IRS acknowledges, “penalties should relate to the standards of behavior they encourage. Penalties best aid voluntary compliance if they support belief in the fairness and effectiveness of the tax system.” IRM 20.1.1.2.1 (11-25-2011) Encouraging Voluntary Compliance.

While perhaps the IRS has the power to penalize taxpayers like the Oosterwijks, the taxpayers’ de minimis $7 delinquency penalty is all that stood in the way of a full abatement. The IRS should apply the First Time Abatement policy by ignoring a de mininimis assessment during the three-year period. Even if the policy were not changed to have a deminimis carveout, when a taxpayer has a long history of compliance and the delinquency is directly attributable to preparer error, perhaps the government should show mercy. After all, as Shakespeare wrote, mercy can have an effect that is “twice blest.” It is needed more so these days as trust in our public institutions and IRS in particular seems to be eroding.

Sometimes doing the right thing means the IRS looking the other way. Even if the law is on its side.

The Fifth Circuit Parts Ways with the Ninth Circuit Regarding the Non-Willful FBAR Penalty

We welcome guest blogger Andy Weiner today to provide insight on a very important case decided last year.  Professor Weiner teaches at Temple Law School where he directs their LLM program in Tax and, starting this fall, also directs their low income taxpayer clinic.  Prior to arriving at Temple, Professor Weiner spent more than a decade as an attorney in the Tax Division of the Department of Justice, initially in the Appellate Section, where he briefed and argued approximately 50 cases throughout the United States Courts of Appeals, and then at the trial level in the Court of Federal Claims Section. He received numerous distinguished service awards during his tenure.  Keith

In United States v. Bittner, the Fifth Circuit reckons with the crack down on hiding wealth offshore. At issue is the non-willful penalty in 31 U.S.C. § 5321(a)(5)(A) for failing to report interest in foreign financial accounts on an annual Report of Foreign Bank and Financial Accounts known as an FBAR. The statute provides the Secretary of the Treasury “may impose a civil monetary penalty on any person who violates, or causes any violation of, any provision of section 5314 . . . not [to] exceed $10,000.” As explained by the Fifth Circuit, the case “hinges on what constitutes a ‘violation’ of section 5314: the failure to file an FBAR (as urged by Bittner) or the failure to report an account (as urged by the government).” Slip Op. at 13. On the surface, it’s a straightforward question of statutory interpretation, and not a particularly close one at that. It becomes more complicated, however, when you consider questions of purpose and fairness, which may help to explain why the Fifth Circuit and the Ninth Circuit split on the issue.

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Bittner has spent most of his life in Romania. Between 1982 and 1990, he lived in the United States and became a citizen. He then returned to Romania and made a fortune as an investor. Through holding companies, Bittner controlled dozens of bank accounts in Romania, Switzerland and Liechtenstein. He did not file timely FBARs for 2007 to 2011 disclosing these accounts. The IRS imposed the maximum non-willful penalty of $10,000 regarding each account for each year. Bittner’s total penalty liability came to $1.77 million.

Bittner argued his liability should be capped at $50,000 based on his failure to file an FBAR for each of five years. As mentioned, that depends on what qualifies as a violation of 31 U.S.C. § 5314 subject to a penalty. Section 5314 states that the Secretary “shall require a resident or citizen of the United States . . . to keep records, file reports, or keep records and file reports, when the . . . person makes a transaction or maintains a relation for any person with a foreign financial agency.” By the Fifth Circuit’s reading, a person violates the statute according when he or she fails to report “a relation . . . with a foreign financial agency.” Bittner pointed out that the statute is not self-effectuating and that the implementing regulations require filing one FBAR that reports all applicable accounts. But that does not affect the meaning of the statute, as the Fifth Circuit explained: “Streamlining the process in this way, . . . cannot redefine the underlying reporting requirement imposed by section 5314.” Slip Op. at 17.

The Fifth Circuit also looked to the surrounding penalty provisions. Section 5321(a)(5) includes both a non-willful and a willful penalty, and the latter unquestionably treats each failure to report an account as a violation. Specifically, 31 U.S.C. § 5321(a)(5)(C) provides that “any person willfully violating, or willfully causing any violation of, any provision of section 5314” is subject to a maximum penalty equal to the greater of $100,000 or 50% of “the balance in the account at the time of the violation.” The reasonable cause exception to the non-willful penalty at 31 U.S.C. § 5321(a)(5)(B)(ii) likewise treats each failure to report an account as a violation, excusing “such violation” if “due to reasonable cause” and “the balance in the account at the time of the transaction was properly reported.” The same word in the definition of the non-willful penalty presumably bears the same meaning as it does in these related provisions.

The Fifth Circuit presents a compelling case based on the text of the statute that each failure to report a foreign bank account is a violation subject to a non-willful FBAR penalty. But why should Bittner, who maintained many foreign accounts ostensibly for legitimate business reasons and who did not willfully fail to report them on an FBAR, owe $1.77 million? Given the unintentional nature of the conduct, there’s little, if any, deterrence value to be gained. What then is the point of such significant penalty liability? The history of the non-willful penalty raises the prospect that it has outlived some of its usefulness.

The original FBAR reporting requirement in the Bank Secrecy Act of 1970 was enforced only by a willful penalty up to $100,000. In 2004, following a report by Treasury that perhaps hundreds of thousands of taxpayers were hiding wealth offshore and not filing FBARs, Congress increased the maximum willful penalty to 50% of the balance in an account not properly reported and added a non-willful penalty up to $10,000. Congress sought to make getting caught prohibitively expense and installed the non-willful penalty as a floor on the cost of non-compliance. Then, in 2010, Congress enacted the Foreign Account Tax Compliance Act, which required foreign banks to report account information of U.S. taxpayers. Bank reporting has proven much more efficient and effective at enforcing FBAR compliance and weakened the justification for the maximum non-willful penalty.

Still, the maximum penalty has its place, for example, as a proxy for taxes that the account holder avoided. Finding the appropriate balance is a matter of IRS discretion and the penalty mitigation guidelines at IRM 4.26.16-2. A person must cooperate with the examination and have a clean record in terms of prior FBAR penalty assessments, criminal activities, and civil tax fraud in any year of a non-willful FBAR violation. If these criteria are met, examiners are instructed to “limit the total mitigated penalties for each year to the statutory maximum for a single non-willful violation,” unless “in the examiner’s discretion . . . , the facts and circumstances of a case warrant a different penalty amount.” IRM 4.26.16.5.4.1 (06-24-2021). Among the factors an examiner should consider is “the harm caused by the FBAR violation,” i.e., lost tax revenue. IRM 4.26.16.5.2.1 (06-24-2021).

There is no indication why the IRS sought the maximum penalty liability against Bittner. The Fifth Circuit seemed to assume that Bittner’s liability was justified by “Congress’s central goal in enacting the BSA . . . to crack down on the use of foreign financial accounts to evade tax.” Slip Op. at 22. The Ninth Circuit in United States v. Boyd, 991 F.3d 1077 (2021), on the other hand, observed that Boyd amended her return to include income from her foreign bank accounts and proceeded to conclude that her non-willful penalty liability from failing to report 13 accounts in one year could not exceed $10,000. Tax avoidance (or the lack thereof) weighs heavily on courts notwithstanding that the relevant information is not necessarily disclosed in FBAR cases.

The lesson here for foreign account holders is to cooperate with an examination and pay the tax owed on income from foreign bank accounts. If the IRS does not mitigate the non-willful penalty liability, the account holder is in position to seize the higher equitable ground in court. The lesson for the IRS is to follow the mitigation guidelines and consider any departures from those rules carefully. The Supreme Court may take up Bittner to resolve the conflict with the Ninth Circuit, in which case I would expect it to affirm that each failure to report a foreign bank account is a violation of section 5314. But that will not end the debate over the appropriate level of non-willful penalty liability. To the contrary, the more the IRS has discretion, the more likely those disputes will endure.

2021 Year in Review – Graev

Maybe it’s too much to devote one year in review post to a single issue, but Graev has dominated case decisions the past few years and maybe, maybe not, is on its way out.  As we reported and blogged about here, the now stalled Build Back Better legislation has a provision that will eliminate Graev, not just going forward, but going back over 20 years.  Not since the retroactive elimination of the telephone excise tax has Congress tried to undo itself in such a grand way.  Since this may be the last hurrah for Graev, why not send it out in style or, if it remains, why not remind ourselves how a poorly worded piece of legislation can cause so much havoc.

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Since the IRS has noticed the existence of IRC 6751(b), it seems now to have procedures in place to ensure that the immediate supervisor of the employee imposing the penalty actually approves the penalty imposition.  If the IRS has finally figured this out, why then repeal the legislation now and why does it receive a relatively high score from Congress for repealing it?  One suggestion concerns a whole bunch of old shelter cases that exist out there in pre-notice of deficiency status in which the IRS failed to follow the now more clearly defined rules of IRC 6751(b).  If true, it becomes easier to see why the administration would push for retroactive repeal and why certain groups of taxpayers would push back.  While we contemplate what might happen in the future, let’s look at the more important Graev decisions of 2021.

Graev and the Fraud Penalty

I posted on a decision that troubled me because when the IRS pursues a taxpayer criminally, the case goes through a myriad set of approvals.  Yet in Minemyer v. Commissioner, T.C. Memo 2020-99 – a case that took 10 years to decide – the Court found that the IRS did not follow IRC 6751(b) and stripped off the civil fraud penalty following a criminal tax case.  I wrote about the Minemyer case here and expressed surprise that IRC 6751(b) would stop the application of the fraud penalty in a case that involved a prior prosecution of the taxpayer, since the assertion of the fraud penalty following prosecution occurred automatically, with the hands of the agent and the agent’s supervisor essentially tied.  Of course, the statute does not specifically address prior criminal cases or create any special exception for them.

The Tax Court followed up the Minemyer case with a precedential decision in Beland v. Commissioner, 156 T.C. No. 5 (2021), where the Tax Court determined that the fraud penalty the IRS sought to assert failed the requirements of IRC 6751(b) allowing the taxpayers to avoid the 75% penalty proposed by the IRS without getting to the merits.  The Court issued this opinion granting partial summary judgment on the fraud issue five years after the case was filed. 

When a revenue agent seeks to impose the fraud penalty, the agent must send the case from exam over to obtain approval from the fraud technical advisor (FTA).  The FTA is a Small Business/Self Employed revenue agent specially trained on tax fraud issues. The IRS set up the system of having agents refer cases to FTAs so that an investigator trained specifically in fraud detection could determine if the revenue agent had gathered enough information to support the fraud penalty and to allow the FTA to determine if this case should chart a path toward criminal prosecution prior to imposition of the civil fraud penalty. See IRM 25.1.2.2 (08-12-2016).

Requiring that the imposition of the fraud penalty first go through an FTA seems to provide even better protection against the use of the fraud penalty as a bargaining chip than having the immediate supervisor sign off on the penalty, but the statute has a specific structure applicable to all penalties.  Striking the fraud penalty in this situation may be part of what’s causing Congress to rethink its passage of IRC 6751(b), but for the reasons discussed in a post by Nina Olson, that seems too radical a fix to a problem that it could resolve with better statutory language.

Graev and the Early Withdrawal Excise Tax

Pulling money out of a retirement account before reaching 59 and ½ and without meeting one of the statutory exceptions in IRC 72(t) triggers a 10% excise tax usually referred to as a penalty and determined by bankruptcy courts to be a penalty for purposes of priority classification.  In Grajales v. Commissioner, 156 T.C. No. 3 (2021), the Tax Court determined that the 10% exaction imposed under IRC 72(t) is not a penalty for purposes of whether the IRS must obtain supervisory approval prior to its imposition.  The amount at issue in this precedential opinion was $90.86 and the case was litigated by Frank Agostino, the godfather of IRC 6751(b) litigation. See Frank’s brief here, and the government’s here.  Frank lost this one but given the way that most people look at this exaction, his arguments were not illogical.

Conservation Easement Cases

In Oconee Landing Property LLC et al v. Commissioner, Dk. No. 11814-19, the Tax Court entered a very substantive order granting partial summary judgment to the IRS on the issue of penalty approval.  If the Court still designated orders, I suspect it would have designated this one.

The taxpayer does not argue in this case that the IRS did not obtain the penalty approvals prior to the communication with it that the IRS had asserted a penalty.  Although the prior approval issue exists in most IRC 6751(b) cases, here the issue focuses on the form and manner of the approval, particularly as it relates to summary judgment.  It asserts that the penalty lead sheet in the file “does not identify Ms. Smithson’s [the immediate supervisor] role … or even a date of signature.”

In this case, the approval occurred through email rather than by a signing of the same paper by the agent and the immediate supervisor.  This type of approval has no doubt become quite common during the pandemic while many employees and managers have been working remotely.  It could also be common in situations where the employee and the manager work out of different offices.  Obtaining acceptance of this type of approval is important for the IRS.  One hurdle it has here and in many other cases involves proving that the person signing the approval is, in fact, the immediate supervisor of the employee imposing the penalty.

When is Supervisory Approval Necessary

In Walquist v. Commissioner, 152 T.C. No. 3 (2021), the issue focused on the IRS’s Automated Correspondence Exam (ACE) software. ACE automatically processes taxpayer returns. In many cases, ACE handles returns from receipt to closing with “minimal to no tax examiner involvement.” In Walquist, ACE processed the taxpayer’s 2014 tax return, assessed a §6662 penalty, and issued the notice of deficiency automatically and without any human interaction. The Tax Court found that because the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner, the penalty was “automatically calculated through electronic means.”

This decision creates a dichotomy between low-income taxpayers whose cases are regularly handled by somewhat automated processes and higher income taxpayers whose cases are not.  The Court did not need to issue a precedential opinion in a case in which the taxpayers were unrepresented tax protestors, yet decided to do so despite the inability of the adversarial process to work effectively.  The Court heard only from the government and clearly expressed displeasure at the unfounded arguments advanced by these taxpayers.  The decision leaves a bad taste in my mouth for the way it casually treats an issue involving many low-income taxpayers without giving lawyers for low-income taxpayers the opportunity to present arguments explaining why this result should not attach.  I have a working paper on the topic of precedential opinions in pro se cases and possible solutions to the creation of precedent where only the government has a real voice.

Another Twist on Death and Taxes

In Catlett v. Commissioner, T.C. Memo 2021-102 the Tax Court dismisses a case for lack of prosecution over seven years after the petitioner filed the case.  He participated actively in the case – at least he was active in seeking continuances and some discovery – until he died.  When he died, the Court and the IRS tried to find a family member to take over the case.  When no one would take over the case, the Court dismissed it for failure to properly prosecute.  I think it comes out as an opinion rather than an order because of the Court’s discussion of the burden on the IRS regarding the penalties it sought to impose.

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Mr. Catlett was a serious tax fraudster.  He partnered with an IRS employee to defraud the IRS by creating fictitious losses.  He helped over 250 clients reduce or eliminate their taxes through the fictitious loss scheme.  Eventually, he as caught, convicted by a jury and, in 2011, sentenced to 210 months of imprisonment.  That’s a long time for a tax crime.  He died in prison.

The case doesn’t talk about why the IRS does not seem to have made a restitution assessment.  The timing of his conviction came shortly after these types of assessments became available to the IRS and perhaps it did make a restitution based assessment but it also decided to give his returns a good, old fashioned audit.  As is customary in a criminal case, the IRS did not begin its audit until he was convicted.  So, the IRS decides to dedicate the precious resources of a Revenue Agent (RA) to audit someone who is in prison for almost 20 years and who owes almost $4 million in restitution.  Mr. Catlett fought the audit by refusing to provide documents and by challenging the summonses issued by the RA but the IRS overcame these challenges and obtained voluminous records which it used to reconstruct his income using the bank deposits method. 

Ultimately, the IRS issued a notice of deficiency for 2006-2010 and he petitioned the Tax Court in June, 2014.  Three times his case came up for trial – June 2015; March 2016 and December 2016.  Each time he requested a continuance.  The first two times it was granted.  Trying Tax Court cases involving incarcerated individuals creates many challenges.  It is difficult to get them out of prison and to the Court.  Often, the Court will continue these cases though for someone with a prison sentence the length of Mr. Catlett’s continuance of the case does not make as much sense.  The third time his case was on a calendar Judge Lauber was presiding, and he retained jurisdiction of the case rather than continuing it.  He ordered annual status reports.

That seems better than simply shuffling the case to the next judge when the person will be incarcerated for another 10 years, but 10 years is a long time to hold onto a case.  Judge Lauber is one of the most, if not the most, efficient and productive of Tax Court judges.  I am sure he was not excited about holding onto a case for so long but the choices in these situations are mostly bad choices.  Mr. Catlett’s death serves as the event that moves the case along.

When Mr. Catlett died in 2020, word eventually reached the Tax Court and the IRS.  Here’s what happened at that point:

After an expansive search respondent located three members of petitioner’s family. Respondent’s counsel explained to each of them the posture of this litigation, but they indicated that they wanted nothing to do with the case. When respondent advised them that he intended to file a motion to dismiss, they again confirmed that they would not participate. We gave all three family members notice of the trial and offered them the opportunity to appear. They declined to appear, and no other representative appeared on petitioner’s behalf. Under these circumstances we have no choice but to dismiss the case for lack of prosecution. The decision that we enter will sustain all adjustments insofar as petitioner bears the burden of proof. See Branson v. Commissioner, T.C. Memo. 2012-124, 103 T.C.M. (CCH) 1680, 1684-1685.

It’s hard to blame the family members for not wanting to get involved, and it’s not at all clear that their involvement would be meaningful.  The Court does not talk about any assets owned by Mr. Catlett, but I suspect there were none.  The result of this Tax Court case was almost certain to be an assessment with no prospect of collection.  You might ask yourself why the IRS would dedicate the precious resources of the RA in this pursuit not to mention the time spent by the Chief Counsel attorney over the years and the Tax Court.  Yet, that’s what I think this case was about – assessing an uncollectible tax when the Government already had a $4 million restitution order and was paying to house and feed Mr. Catlett for almost a decade.

My suggestion would have been to skip the audit and all of the efforts of the persons working for the Government over the past decade and focus on collecting the restitution order but that was not the choice made.  Once Mr. Catlett passed away and no family member stepped forward, the IRS moved to dismiss the case for lack of prosecution.  Because it had imposed numerous penalties (additions to tax) on Mr. Catlett, including the fraud penalty, and because of the burden of production with respect to these liabilities was on the IRS, the Court could not simply dismiss the case but had to weigh whether the IRS met its burden.

The Court finds that the IRS did meet its burden.  This exercise requires yet more work for the Chief Counsel attorney and the Court.  It finds the IRS manager gave the appropriate penalty approval required by IRC 6751(b).  It finds the factors necessary to prove fraud for some of the years and negligence for others.  It finds he owes other penalties and provides reasons for each finding. 

The system works.  In this case the system seems like a colossal waste of time.  Now a Revenue Officer will be assigned to this case and an uncollectible assessment will stay on the books for 10 years with required annual reminders and other actions that will not add additional revenue to the coffers.  I hated to work these types of cases because it seemed like such a waste of time and resources.  I can’t imagine those working on the Catlett case feel differently.

Boyle Strikes Again: Incarcerated Individual Subject to Delinquency Penalties Even Though Attorney Embezzled Funds and Failed To File His Tax Returns

We have often discussed the reach of the 1985 Supreme Court case United States v. Boyle. Section 6651(a)(1) and (2) impose delinquency penalties for failing to file a tax return or pay a tax unless the taxpayer can establish that the failure was due to reasonable cause and not willful neglect.  Boyle essentially stands for the position that taxpayers have a nondelegable duty to be aware of tax deadlines. An agent’s incompetence or willful misconduct will not excuse the taxpayer from delinquency penalties.

Lindsay v US is the latest case to apply the principle.

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Lindsay was incarcerated and executed a POA to Bertelson, an attorney, to manage his affairs, including filing his tax returns.  The attorney assured Lindsay he was doing so for the years 2012-15; instead he failed to file the returns and for good measure embezzled hundreds of thousands of dollars. The actions resulted in Lindsay receiving $705,414.61 in actual damages and $1 million in punitive damages.

Lindsay eventually filed his tax returns and paid over $425,000 in delinquency penalties. He filed a claim for refund; IRS rejected and he filed a suit in district court. The district court, contrary to the magistrate’s recommendation, granted the government’s motion to dismiss, citing Boyle as precluding a claim for relief. Following a timely appeal, the Fifth Circuit affirmed. In so doing it applied Boyle to Lindsay’s somewhat sympathetic circumstances:

Lindsay claims that he exercised ordinary business care and diligence by giving Bertelson his power of attorney and by directing Bertelson to file his income tax returns and to pay his taxes. Lindsay routinely asked Bertelson whether he was handling Lindsay’s tax obligations, and Bertelson said that he was. In Lindsay’s view, he has a reasonable cause for late filings and delayed payments because he used ordinary business care and prudence but was nevertheless unable to file his returns and pay his income taxes due to circumstances beyond his control, i.e., Bertelson’s malfeasance.

Lindsay’s position was rejected in BoyleBoyle established that taxpayers have a non-delegable duty to promptly file and pay their taxes. 469 U.S. at 249–50. Unlike cases where taxpayers seek and detrimentally rely on tax advice from experts, “one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due.” Id. at 251. Lindsay’s argument fails.

The opinion disposed of a couple of other of Lindsay’s arguments. He also raised the IRS’s own definition of unavoidable absence as excusing delinquency. Citing George v Comm’r, a 2019 TC Memo opinion that collects cases on the point, the Fifth Circuit panel emphasized that the mere fact of incarceration itself does not mean there was reasonable cause to miss deadlines.

Lindsay’s final argument was that  Boyle does not control in cases where a taxpayer is not “physically and mentally capable of knowing, remembering, and complying with a filing deadline.” The opinion stated that even if Boyle created an incapability exception he could have done more, “much like he conducted business and employed a CPA while incarcerated.” 

Conclusion

Lindsay, like many other taxpayers, is out of luck when it comes to trying to recover delinquency penalties that can be directly linked to an agent’s misconduct or incompetence. He did have some recourse, however, as he was awarded significant compensatory and punitive damages from his embezzling attorney. 

CIC Fallout: Anti Injunction Act Bars Motion for Protective Order

US v Meyer presents a somewhat unusual context for a court’s application of the Anti Injunction Act. Meyer stems from an injunction action due to allegations that Meyer promoted “an abusive tax scheme that result[ed] in scheme participants claiming unwarranted federal income tax deductions for bogus charitable contributions.” In 2018, the parties settled that suit and filed a joint motion for permanent injunction. The settlement expressly did not preclude the US from “pursuing other current or future civil or criminal matters or proceedings,” or preclude Defendant from “contesting his liability in any matter or proceeding.”

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Following the settlement, the IRS began a civil investigation and proposed approximately $7 million in Section 6700 civil penalties. Following the proposed assessment, Meyer sought a protective order from the federal district court that had previously been the forum for the injunction proceeding. In particular, Meyer alleged that the IRS’s computation of the proposed 6700 penalty improperly relied on admissions he had made in the injunction proceeding, in violation of Federal Rule of Civil Procedure 36(b). FRCP 36(b) provides that “an admission under [Rule 36] is not an admission for any other purpose and cannot be used against the party in any other proceeding.”

The request for a protective order was initially heard by a magistrate judge.  In April, that judge issued a report and recommendation concluding that Meyer’s request for relief was barred under the AIA. In so doing, the magistrate judge held that the AIA applied even though Meyer did not bring the suit but instead sought a protective order in a suit that the US had brought (recall that the AIA provides that  “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person….”). Meyer had sought relief based upon a federal district court’s broad power under Fed Rule Civ Procedure 26 which upon a showing of “good cause,” provides that a court may issue a protective order providing a variety of remedies, such as precluding discovery altogether or “specifying terms … for the disclosure or discovery.”

In finding that the AIA barred the request for a protective order stemming from an alleged violation of Fed Rule Civ Procedure 36 from a government-brought injunction case, the magistrate noted that there was no case law squarely on point but looked to analogous cases applying the AIA where taxpayers sought to limit information that the IRS could use in civil proceedings. According to the magistrate, Meyer’s relief request was essentially requiring the IRS to recalculate the penalty and “preclude the IRS from using certain information to assess a tax penalty and is, therefore, impermissible under [the AIA].”

In finding that the AIA did not allow the court to issue a protective order, the magistrate punted on the issue as to whether Rule 36 had any impact on the IRS’s proposed penalty assessment, and whether a “proceeding” for Rule 36 purposes also included an IRS civil penalty examination.  The magistrate noted that the substantive issue could be teed up in a refund proceeding.

Following the magistrate’s report, Meyer timely appealed the recommendation, with the district court then as per Fed Rule Civ Procedure 72 reviewing the matter on a de novo basis. The federal district court judge affirmed and adopted the magistrate’s order, though the opinion is somewhat noteworthy because it addresses Meyer’s additional filings with the court briefly dismissing Meyer’s argument that CIC Services supported finding that the AIA did not apply:

In the present case, the relief Defendant seeks falls squarely within the contours of the Anti-Injunction Act—namely, to limit the information the IRS may consider in its assessment of $7,066,039.00 in tax penalties under  § 6700. See ECF No. [98] at 5 (requesting that the Court “issue an order preventing the Government and its client, the IRS, from using [Defendant’s] Rule 36 Admissions to support factual conclusions in the IRS’s Section 6700 Penalty examination.”); ECF No. [105] at 10 (“request[ing] that this Court enter an order directing the Government that it may not use the Defendant’s RFA Responses for any purpose other than as admissions in this proceeding.”) (emphasis in original); see also CIC Serv., 141 S. Ct. at 1593 (“suits sought to prevent the levying of taxes … [cannot] go forward.”). Thus, the Court agrees with [the magistrate judge’s] conclusion that Defendant’s Motion is barred under the Anti-Injunction Act.

Conclusion

As did the magistrate judge’s, the district court’s order ended with a statement that Meyer was not without recourse as he could bring a refund proceeding and thus get a court to address the merits of Meyer’s claim that Federal Rule of Civil Procedure 36(b) should bar the IRS from using admissions from a separate injunction in calculating a 6700 penalty in a civil exam. Of course, a refund suit is predicated on Meyer satisfying Flora, though the 6700 penalty has special statutory rules allowing for partial payment to secure court review.

Reliance and Omitted Income: Taxpayer Cannot Avoid Penalties Even When Using Longtime Preparer

I do not prepare tax returns. But I feel for the long-suffering preparers who try their best to get the information from clients to prepare an accurate tax return.  For people with a variety of sources of income, like self-employed consultants with multiple clients, the process is burdensome—at least when compared to employees who more or less automatically get W-2s with withholding that tends to approximate liability.  I also feel for taxpayers who have income from a myriad of sources because collecting and insuring that the income from each source that gets reported can prove difficult.  Neither taxpayers nor preparers have a computer system akin to the IRS underreporter program that matches all of their third party returns against the amounts reported on the returns.  If such a program existed presubmission to the IRS, returns would be much more accurate.

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The recent case of Walton v Commissioner involved a psychologist whose 2015 tax return failed to include almost $170,000 in compensation. Prior to 2015, Walton had been employed with a consulting firm. In 2015 she went out on her own and had multiple clients. When it came time to file her 2015 return, she attempted to give all her information to her preparer but, as we will see below, she may not have given all of her 1099’s and the preparer failed to include a sizable chunk of her income. The issue in the case involved substantial understatement penalties-namely whether the IRS satisfied the supervisory approval requirement under 6751(b) or whether her omission should be excused by good faith reliance on her longtime experienced CPA return preparer.

In this post I will discuss the latter issue though I note the opinion discusses that the 6751(b) approval was not necessary because of the exception to the supervisory approval requirement for a “penalty automatically calculated through electronic means.” The opinion discusses how Walton’s omission was flagged by the IRS’s Automatic Underreporting Program (AUR) and thus was “determined mathematically by a computer software program without the involvement of an IRS examiner” leading it to conclude that the penalty was “automatically calculated through electronic means.” (citing Walquist v Comm’r, which Keith discussed in Automatically Generated Penalties Do not Require Managerial Approval and which Bob Kamman also addressed in Some Facts About the Walquist Case, Along with Some Nuance).

After rejecting the 6751(b) defense the court turned to whether Walton had reasonable cause for the omission and whether she acted in good faith. In setting up the issue the opinion notes that reliance of a qualified and competent preparer is not enough; there must be evidence that the taxpayer acted with diligence and prudence. 

In evaluating whether she acted with both prudence and diligence, the opinion discusses the back and forth between Walton and her preparer. As a starting point the atmosphere here is bad: the return left off almost 1/3 of her total compensation. Yet the exchange showed she gave her preparer a starting point on income that was well in excess of the 1099’s she had sent over. In January of 2016 she sent an email to her preparer stating that “I am sure I need to pay taxes. If I did the math right, I earned about $525k in 1099 pay.” A month later Walton sent over a W-2 showing some income from her former employer as well as five 1099 MISC’s totaling over $350,000.  Fast forward to April 12: another CPA at the firm sent Walton an email asking a bunch of questions on unrelated issues as well as if she was sure that she had sent all the 1099’s as the total was well below the 525,000 estimate in her January email. 

Two days later Walton responded to the questions but did not answer the 1099 MISC question.  After that exchange the CPA firm obtained an extension to October 15th. On September 29 her preparer (who had done her taxes for twenty years and prepares over 1,000 returns a year) emailed Walton a list of things he needed to complete the return. That did not include a specific ask for 1099 MISC’s but instead focused on 1099- DIV, business and travel expenses and other issues. Walton responded and said that she “attached the 1099s to the last emails”, and the preparer replied that “I have all the 1099s and the kids accounts, … the taxes and interest on the house …[and] the charities as well.”

The opinion notes that it is the preparer’s practice when there is a discrepancy between a client estimate and documentation to rely on the numbers in the document. Unfortunately for Walton, she testified that she did not review the return before the preparer e-filed it as she trusted his expertise.  That admission was fatal to the defense—even though there was some uncertainty as to whether she gave all 1099 MISC’s to her preparer, the failure on Walton’s part to review the return led to a finding that she failed to act with the prudence and diligence necessary to avoid the penalty.

Conclusion

In reading this opinion I was reminded of one of my early blog posts back in 2013,  Omitted Income, Accuracy-Related Penalties and Reasonable Cause. That post discussed Andersen v Comm’r, a summary opinion where a taxpayer also used a longtime preparer and left off a significant amount of W-2 income (about $28,000) from the return, but the court still found that they should not be subject to civil penalties. The opinion found that the taxpayer acted with reasonable cause and good faith, looking to an almost 50 year record of taxpayer compliance, only a slight difference in income from the year in question and the prior year’s return and circumstances that showed how the preparer mistakenly believed that he had all the information returns from the taxpayers. 

All of these cases are fact specific. Walton does reveal how burdensome our filing system is. The amount of time necessary to fish for all information returns is wasteful and prone to error. Taxpayers can set up online accounts with the IRS so that they (and their preparers) can see what information returns IRS has received, but that system is not easily accessible. While I understand the court’s conclusion in Walton, we would all be better off if taxpayers and their preparers could easily see all information returns on file. Our system does not make it easy. I am glad I do not prepare tax returns for a living.