March 2022 Digest

April 1, 2022 by Leave a Comment

Spring has arrived and the Tax Court has resumed in-person sessions for many locations. In Denver, we have our first in-person calendar call on Monday. I’m looking forward to it, but also need figure out if any of my suits still fit. PT’s March posts focused on issues with examinations, IRS answers, and more.

A Time Sensitive Opportunity

Loretta Collins Argrett Fellowship: The Loretta Collins Argrett Fellowship seeks to support the inclusiveness of the tax profession by encouraging underrepresented individuals to join and actively participate in the ABA Tax Section and Tax Section leadership by providing fellowship opportunities. More information about the fellowships and how to apply are in the post. Applications are due April 3.

Taxpayer Rights

The 7th International Conference on Taxpayer Rights: Tax Collection & Taxpayer Rights in the Post-COVID World: The virtual online conference is from May 18 – 20 and focuses on the actual collection of tax. The agenda and the link to register are in the post. Additionally, the Center for Taxpayer Rights is hosting a free workshop called The Role of Tax Clinics and Taxpayer Ombuds/Advocates in Protecting Taxpayer Rights in Collection Matters on May 16 and a link to register is also in the post.

How Did We Get Here? Correspondence Exams and the Erosion of Fundamental Taxpayer Rights – Part 1: Correspondence exams now account for 85% of all audits, up from about 80% in the previous two years. This post looks at data on correspondence audits and identifies a disproportionate emphasis on EITC audits which burden and harm low income taxpayers. 

How Did We Get Here? Correspondence Exams and the Erosion of Fundamental Taxpayer Rights – Part 2: This post considers the long-term goal of audits, along with recommendations for how the IRS can improve correspondence exams. Such recommendations include utilizing virtual office audits; using plain language, tailored, and helpful audit notices; and assigning the audit to one specific person at the IRS. Making correspondence audits more customer friendly could fall under the purview of the newly created IRS Customer Experience Office.

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Opportunities for Improving Referrals by VITA Sites to LITCs: Taxpayer rights could be better protected if VITA sites better understood when a referral to an LITC may be necessary and how to make such a referral. This post explores opportunities to improve this process, including a training initiative begun by the Center for Taxpayer Rights.

Tax Court Updates and Information

Tax Court is on the Road Again: The Tax Court officially resumed in-person calendars on Monday, February 28, but select calendars are still being conducted remotely. Practitioners who have recently attended in-person calendars share more information about what it’s like to be back.

Ordering Documents from the Tax Court: A “how to” on ordering documents from the Court. Phone requests are currently the only way, but in-person requests may resume once the Court reopens to the public. Both options come with a per page or per document fee.

Tax Court Proposed Rule Changes: The Tax Court has proposed rule changes which are largely intended to clean up language or more closely conform the Tax Court rules to the Federal Rules of Civil Procedure. It invites public comments on the proposals by May 25, 2022.

Tax Court Decisions

Tax Court Takes Almost Five Years to Decide a Dependency Exemption Case: Hicks v. Commissioner highlights the procedures required to claim a qualified child as a dependent when the child does not reside with the taxpayer. The case is noteworthy for the length of time it took the Court to issue an opinion, especially because there were no continuances or other reasons for a delay.

Jeopardy Assessment Case Originating in the Tax Court: The opinion Yerushalmi v. Commissioner is rare because the Tax Court reviews whether jeopardy exists in the first instance, rather than following a district court decision. The post looks at the case, the standard of review, and the facts that can be relevant to the Tax Court when it must decide whether the IRS’s jeopardy assessment was reasonable.

Tax Court Answers

Tax Court Answers: There are issues caused by requiring the IRS to file answers in small tax cases. It delays a review of the case on its merits, the process is slow and impersonal, and there are risks that a taxpayer won’t understand what the answer says. The Court should consider conducting an empirical study, engaging with taxpayer representatives, or forming a judicial advisory committee to identify best practices.

Making the IRS Answer to Taxpayers…By Making the IRS Answer: In the first of a three-part series looking at issues with IRS Counsel answers, Caleb looks at the case of Vermouth v. Commissioner. The case emphasizes the importance of the administrative file during the pleading stages of litigation. Cases involving bad answers and their impact on the burden of proof and burden of production are also discussed.

Making the IRS Answer to Taxpayer Inquiries…By Making the IRS Reasonably Inquire: Tax Court Rule 33(b) requires a signer of a pleading to reasonably inquire into the truth of the facts stated therein. To what degree are IRS Counsel attorneys required to reasonably inquire when filing an answer? This post explores that question and sheds some light on the Court’s expectations.  

Making the IRS Answer to Taxpayer Inquiries…By Making the IRS Reasonably Inquire (Part Two): Continuing the discussion of the IRS’s responsibilities under Rule 33(b), this post looks closer at the consequences to the IRS when a bad answer is filed. Caleb examines the Court’s response in cases where an administrative file was excessively lengthy or not available quickly enough and shares the lessons to be learned.

Circuit Court Decisions

Naked Owners Lose Wrongful Levy Appeal: Goodrich et. al. v. United States demonstrates the interplay of state and federal law upon lien and levy law under the Internal Revenue Code. The 5th Circuit affirmed that a taxpayer’s children had a claim against their father’s property, but only as unsecured creditors according to state law. As a result, the children’s interests were not sufficient to sustain a wrongful levy claim.

Confusion Over Attorney’s Fees in Ninth Circuit Stems from Statute and Regulation…: In Dang v. Commissioner the parties debated the starting point in which reasonable administrative costs are incurred in the context of a CDP hearing. The IRS argued it’s after the notice of determination. Petitioners argued it’s after the 30-day notice which provides the right to request a CDP hearing. The Court decided no costs were incurred before the commencement date of the relevant proceeding without deciding when that date was. The case provides another reason why the statute and regulation involving the recovery of administrative costs from administrative proceedings should be changed.

Attorney’s Fees Cases in the Ninth Circuit and Requesting a Retirement Account Levy: The concurring judge in Dang demonstrates that he understands the entire argument and finds that the exclusion of collection action from the definition of administrative proceedings is contrary to the plain language of the statute. 

Oh Mann: The Sixth Circuit Holds IRS Notice Issued in Violation of the APA; District Court in CIC Services Finds Case is Binding Precedent: The decision Mann v. United States is binding on CIC Services and is examined more closely in this post. In Mann, the Sixth Circuit found that the IRS notice at issue was invalid because the public was not provided a notice and comment opportunity. The case is significant because it is another circuit court opinion that applies general administrative law principles to the IRS.

You Call That “Notice”? Seriously?:  General Mills, Inc. v. United States involves refund claims that were made within the two-year period under section 6511, but outside of the six-month period which starts when a notice of computational adjustment is issued to partners. The Court seemingly concluded that notices, unless misleading, need only to comport with statutory requirements regardless of due process considerations. The post also evaluates and discusses the adequacy of common notices in relation to the notice of computational adjustment.

No Rehearing En Banc for Goldring: Is Supreme Court Review Possible?: The issue in Goldring was how underpayment interest should be computed on a later assessed deficiency when a taxpayer elects to credit forward an overpayment from an earlier filed return. The government’s rehearing en banc petition was denied leaving in place the circuit split. IRS Counsel has advised that there are thousands of similar cases, which could result in refunds of multiple millions of dollars, so it is yet to been seen if the government will petition the Supreme Court.

Challenging Levy Compliance: In Nicholson v. Unify Financial Credit Union the Fourth Circuit affirmed the dismissal of a suit to stop a levy brought by a taxpayer against his credit union. The law requires a third party to turn over the property to the IRS and then allows the taxpayer whose property was wrongfully taken to seek the return of that property from the IRS, so suing the credit union is not an effective avenue.

Offers in Compromise

Suspension of Statute of Limitations Due to an Offer in Compromise: The statute of limitations on when the IRS can bring suit to reduce a liability to judgment is at issue in United States v. Park. An offer in compromise suspends the collection statute and can give the IRS more time than a taxpayer would expect. It’s good idea to consider the risks before submitting an offer.

Public Policy and Not in the Best Interest of the Government Offer in Compromise Rejections: Cases where the IRS rejects an offer in compromise based on public policy or for not being in the best interest of the government are reviewed to better understand the reasons for such rejections. The IRS may look at past and future voluntary compliance and criminal tax convictions. The IRS should make offer decisions easily reviewable to provide more transparency in this area.

Correction on Making Offers in Compromise Public: Keith has learned that the IRS has updated the way in which the public can inspect accepted offers. It is by requesting an Offer Acceptance Report by fax or mail. The report, however, only contains limited and targeted information, so FOIA is still the only way to receive broad and general information.

Bankruptcy and Taxes

General Discharge Denial in Chapter 7 Based on Taxes: In Kresock v. United States, a bankruptcy court’s denial of discharge was sustained by an appellate panel due tothe debtor’s bad behavior in connection with his tax debts. It is seemingly unusual for a general discharge denial to occur where the basis for denial is tax related.

Miscellaneous

The Passing of Michael Mulroney: Les and Keith share remembrances of Michael Mulroney, an emeritus professor at Villanova Law School.

Congress Should Make 2022 Donations to Ukraine Relief Deductible in 2021: In order to encourage taxpayers to make donations in support of Ukraine, this post recommends that Congress create a deduction similar to the one permitted for the Indian Ocean Tsunami Act, which allowed deductions made in the current tax year to be claimed on the prior year’s return.

Filed Under: Administrative Procedure Act (APA), Attorney's fees, Center For Taxpayer Rights, Exam, FOIA, Jeopardy, Monthly Digest, Offer in Compromise, Statutes of Limitation, Tax Court

How Did We Get Here? Correspondence Exams and the Erosion of Fundamental Taxpayer Rights – Part 2

March 15, 2022 by 3 Comments

In my last post, I reviewed compelling IRS data, including from the National Taxpayer Advocate’s 2021 Annual Report to Congress, that show the IRS Automated Correspondence Exam (ACE) system disproportionately harms low income taxpayers and is desperately in need of a fix.  The IRS maintains the batch processing approach to correspondence (corr) examinations is efficient.  But the long-term goal of an audit should be to educate the taxpayer about what they did wrong (or for the IRS to learn what it got wrong), so the taxpayer (or IRS) does not repeat the mistake.  If the taxpayer never responds, or does not understand why additional tax is assessed, then the audit may result in more tax dollars, but from a voluntary compliance and taxpayer rights perspective the audit is a failure.  Correspondence exam, with its batch processing, assembly-line approach, may result in a high number of audits and assessments, but it does not promote understanding and in some cases has a negative compliance effect.  Moreover, researchers report that taxpayers who experience a correspondence audit report relatively low perceived levels of procedural, informational, interpersonal, and distributive justice.

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If the IRS were truly taxpayer-centric and designed its compliance programs from a taxpayer-rights foundation, it would look at the data presented by the Taxpayer Advocate Service in this year’s report, as well as all the past reports, and conclude that the process isn’t working for the lowest income taxpayers.  It would ask itself how it could improve the audit process so that taxpayers engage with the auditor and learn what, if any, error they made and how to avoid it going forward.  That engagement and education is at the heart of voluntary compliance, and while it appears to require more upfront resources, it is way more cost effective in the long run than current correspondence exams, which have little educational value.  For example, in a 2007 TAS survey of taxpayers who experienced correspondence examinations for EITC claims, 45% did not understand how the documents requested by the IRS related to the questions the IRS had.  One study found that only 39.7% of Schedule C taxpayers audited by correspondence recalled being audited at all, as compared to 72% of field audited taxpayers and nearly 80% of office audited taxpayers.

The IRS doesn’t need to look far or use much more in the form of resources to be both more effective and in greater compliance with taxpayer rights.  In this post I will set several recommendations for improving the correspondence exam process.  All of these can be accomplished with a modicum of resources, and you can pay for the rest by minimizing, if not eliminating, the expensive downstream work caused by poorly handled correspondence exams (for a sense of this downstream cost, see Figure 2.9.7, page 156 of the 2021 Most Serious Problems for a chart of average pay of downstream employees).

First, the IRS should rename correspondence exam as “virtual office exam.”  Specifically, the IRS should reap the benefits of the pandemic-spurred “zoom” revolution by designing a virtual correspondence exam process that more closely follows in-person office exam procedures.  With this approach the IRS would still send the taxpayer an audit initiation letter, with a suggested date and time for a virtual audit appointment.  Behavioral researchers have found that people are more likely to respond when an appointment time is set, even if the response is to request a different appointment time. 

Second, the audit initiation letter should set out – in common parlance/plain language — the issue that is being examined (since IRS insists correspondence exams are “single issue” exams) and describe the types of documentation that may be helpful to establish eligibility for a credit or deduction.  Here’s an excerpt of an actual Notice CP-75 (correspondence exam audit initiation letter) sent to a low income taxpayer in February 2022:

Notice how vague the letter is about what, precisely, the IRS is auditing; the letter lists 5 different possible issues, each of which have different eligibility criteria.  This sure doesn’t look like a single-issue audit to me.

This notice goes on to identify the “audit items that require documentation” to be: EIC, Dependents, Filing Status, AOC, CDC Credit.  The notice helpfully includes the following enclosures:

According to the 2021 Annual Report to Congress, only 3% of taxpayers with Total Positive Income under $50,000 were represented in individual correspondence exams.  For unrepresented taxpayers, the above enclosures will be overwhelming and the sheer volume of them could lead an unrepresented taxpayer to just give up.  It is no wonder that the no-response rate for correspondence exam is higher than any other form of exam.  The inability to reach a live assistor to ask questions increases the administrative burden exponentially.  (In FY 2019, IRS answered the correspondence exam phone line 40% of the time.) 

Third, the IRS should completely trash its current notice system and use some of the IT funding it is getting for FY 2022 to replace it with a 21st century system that is flexible and graphically robust in terms of layout, type, and design.  IRS letter format is currently dictated by an aged, obsolete correspondence system that is completely inflexible.  Trying to get a change in wording to an IRS letter can take more than a year of endless reviews and negotiations, and even then you have to wait for the programming to be complete.  There is lots of good research, some conducted by IRS and TAS, about how to communicate complex information.  The benefits field, in particular, has lots of studies about how to plan effective communication.  IRS needs to apply that research to its correspondence exam notices and make them salient to the taxpayer’s specific situation.  Presumably, the IRS knows the exact reason the taxpayer’s return was selected for audit.  The audit initiation letter should include that specific reason, not a list of “and/or” possibilities.  The enclosures should relate to that specific reason.  (If there is more than one reason, then the audit should be conducted as an office or field exam, per the IRS’s own justification for “single issue” correspondence exams.)  The IRS should apply its IT resources to get this done, ASAP.

Fourth, the IRS should assign one audit employee to each case.  The audit initiation letter should include the name, badge number, and phone number of the employee to whom the case is assigned, as is required by IRC §7602(a).  Providing this information “personalizes” the process.  It reassures the taxpayer there is a live human being who will work with you on the case, rather than the impersonal, faceless IRS.  The letter should also encourage taxpayers to contact the office immediately if they need to reschedule or would prefer to conduct the audit by phone or correspondence.  By inviting the taxpayer to call to state their preference, the IRS not only signals its willingness to meet the needs of the taxpayer but also gains an opportunity to talk to the taxpayer about the issues.  This approach also increases IRS accountability.  As it stands today, no one employee is accountable for the conduct of a correspondence exam.  If the taxpayer does not respond, the assigned audit employee should be required to make at least two outbound call attempts (or emails/texts if that is available) at different days of the week and times of day. 

(I note that the IRS frequently justifies its “next available assistor” approach to correspondence exam by saying it is good for the taxpayer.  But all IRS functions where employees maintain case inventories – field exam and collection, Appeals, Counsel, and the Taxpayer Advocate Service – have established some type of buddy system to cover for vacations, sick leave, or training.  And the IRS could treat these taxpayers as adults and give them the choice of speaking to their assigned auditor or the next available assistor.)

Fifth, the audit initiation letter should also include a separate sheet providing information for signing on to the virtual appointment, including the requirement for a phone or other device that has a camera, and providing a contact for the taxpayer to discuss any technological challenges the taxpayer may face.  This is where QR code technology could be helpful, providing links to appropriate sites and information.  If the taxpayer is unable to sign on via a device with a camera, a telephone appointment should be arranged.  When the taxpayer requires specific reasonable accommodations, the audit should be converted to an in-person office exam or conducted via telephone, whichever is best for the taxpayer.

Sixth, when the taxpayer attends the virtual office audit appointment, the auditor should iteratively explain the specific issue that is being reviewed and what the IRS needs to see to establish eligibility.  If the taxpayer has documentation, the IRS auditor should look at it via the taxpayer’s device camera and instruct the taxpayer on how to upload, email or fax it.  As with an in-person office audit, at the close of the appointment the taxpayer should know what additional documentation, if any, is needed to prove eligibility.  The employee should memorialize the requested additional documentation in a letter to the taxpayer (or email if allowed).

Seventh, in order for this approach to work, the IRS must test its Documentation Upload Tool (DUT) or similar technology (such as the virtual office platform) with low income taxpayers to determine whether they are able to access and utilize it.  It should work with both the National Institute of Standards and Technology (NIST) and other government agencies and external groups to identify secure but accessible methods for low income taxpayers to sign on and submit information and documentation digitally.

Eighth, the IRS should adopt in correspondence exams the same procedures it uses in office and field exams for identifying alternative mailing addresses.  This approach will minimize the number of default assessments due to taxpayers moving around, especially low income taxpayers who comprise more than half of the correspondence exam population.

Ninth, with respect to all CTC/EITC audits, the IRS should allow taxpayers to establish proof of residency by using Form 8836 and its accompanying Schedule A.  These forms walk taxpayers through how to prove their child or relative lived with them for more than 6 months by having certain officials or professionals attesting under penalties of perjury and completing the periods of time they either have personal or official-records knowledge of the child’s residence.  In an exhaustive 2005 IRS study, this form was shown to be more reliable and probative than the usual documents and notarized statements the IRS currently accepts.  Since that time, I have recommended the IRS use this form in all EITC audits, which the IRS has steadfastly refused to do.  Given its obvious benefits, including reducing taxpayer burden, the IRS’s refusal is just plain baffling and counterproductive.

Tenth, the IRS should conduct a research study to test the effectiveness of certain messages in eliciting a response from low income taxpayers.  Several studies have already been conducted, including one by Day Manoli and Nicholas Turner on Nudges and Learning: Evidence from Informational Interventions for Low-Income Taxpayers.  This study found that timely reminder notices about the availability of the EITC increased take up of the childless worker EITC by 80% among the test population in the year of the notice.  A similar study designed around increasing responsiveness to correspondence exams, including focus groups exploring how letter recipients perceived the messages, could greatly enhance taxpayer communication and participation. 

The IRS should also build upon the important research conducted by TAS in 2016 and 2017 in which it sent out educational letters, under the signature of the NTA, to taxpayers whose returns claiming children had broken certain rules in the Dependent Database.  The letter referenced the specific issue and explained the eligibility rule in plain language.  One part of the study offered a toll-free Extra Help line to get questions about eligibility for the EITC and the CTC.  The letters had significant future compliance effects in several areas, without the cost of an audit.  The IRS should conduct a follow up study including focus groups to determine whether taxpayers understood the eligibility rules as a result of the letter.

The IRS recently announced the permanent establishment of the Customer Experience Office.  From the announcement, it appears the office will primarily focus on taxpayer service.  I hope the office defines “taxpayer service” more broadly, to include how taxpayers are served by the audit and collection process of the IRS (answer = poorly).  If it does so, the correspondence exam process is a good place to start.  While it is at it, the office can look at how to create a ”feedback loop” so correspondence auditors can learn what happens to the cases after they leave correspondence exam, as this post suggests.  Taxpayers who are under audit, and their representatives, will be enormously grateful for any improvements, and the rest of us taxpayers will be very happy that the IRS no longer wastes resources and violates taxpayer rights in this audit process.

Filed Under: Center For Taxpayer Rights, Exam, Taxpayer advocate

How Did We Get Here? Correspondence Exams and the Erosion of Fundamental Taxpayer Rights – Part 1

March 14, 2022 by 3 Comments

Over the past several decades, correspondence examinations have become the IRS’s primary method for auditing individual taxpayers.  The Transactional Records Access Clearinghouse (TRAC) at Syracuse University just reported that of the 659,003 individual audits conducted by the IRS in Fiscal Year (FY) 2021, all but 100,000 were conducted by correspondence.  TRAC reports that correspondence exams now account for 85% of all audits, up from about 80% in the previous two years.

Originally designed for “less complex” matters, correspondence exams are now used for complex factual issues including the child tax credit, earned income tax credit, self-employment income (gross receipts and expenditures), and charitable deductions.  Correspondence is also the only method applied in “unreal” audits – examinations that the IRS doesn’t count as “audits” under IRC § 7602 because it says they don’t arise to an examination of the taxpayer’s books and records.  Through the Automated Correspondence Examination (ACE) system, unless the taxpayer responds in writing, a correspondence exam automatically moves from one stage to the next, up to the issuance of a Notice of Deficiency, without any human intervention.

IRS maintains that correspondence exams are an efficient and cost-effective method of conducting audits.  For example, in a summer 2021 release, the IRS justifies the low cost of these audits ($150 for the IRS!) by highlighting the minimal burden on taxpayers.  This blog will show just how wrong the IRS is about the burdens correspondence audits impose on taxpayers and their consequences.

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Over the decades, advocates for taxpayers, myself included, have consistently criticized this method and maintained it does not adequately protect taxpayer rights, including the right to be informed, to pay no more than the correct amount of tax, to challenge the IRS and be heard, and to a fair and just tax system.  Recently, The Tax Law Center at New York University and the Center for Taxpayer Rights published a paper about this topic, Exclusionary Effects of the IRS Correspondence Audit Process Warrant Further Study, in which we question the effectiveness of correspondence exams and propose additional research and pilots.

To get a sense of the disproportionate impact the IRS overall audit strategy has on Earned Income Tax Credit taxpayers, and why it is so important not only to revise that strategy but also to reform the audit process, please take a look at some rather stunning statistics from the IRS Statistics of Income compliance webpage.  Table 17 sets forth Exam Coverage and Recommended Additional Tax After Exam, by Type and Size of Return, for Tax Years 2010-2018.  (I am using Tax Year (TY) 2018 because it best aligns with the NTA Annual Report numbers, which use Fiscal Year (FY) 2019, discussed later in this post). 

Total TY 2018 individual tax returns filed:                                                      153,927,628

Total TY 2018 individual tax returns with EITC:                                              26,492,486

EITC returns are 17.2% of all TY 2018 individual returns.

Total audit closures of TY 2018 individual tax returns:                                  234,543

Total TY 2018 individual tax return audit closures selected for EITC:            165,611

EITC returns are 70.6% of all TY 2018 individual audit closures.

Total TY 2018 individual audit closures with no change:                                41,276

Total TY 2018 individual audit closures, selected for EITC,with no change: 28,277

EITC returns are 68.5% of all TY 2018 individual no-change audits.

What this data tell us is that over 70% of all IRS individual audit closures for TY 2018 returns involved EITC despite the fact that only 17.2% of individual income tax returns claim the EITC.  This is up from what I reported in the 2005 Annual Report to Congress, when 48% of IRS individual examinations involved the EITC despite only 17% of individual income tax returns claim the EITC.  And remember – these “audit” numbers don’t include “unreal audits” involving EITC, such as math errors under IRC § 6213.  Further, EITC audits constitute more than 2/3 of the no-change individual audit closures.  Now, this figure does not take into account downstream adjustments to proposed assessments in appeals or Tax Court, or abatements in audit reconsiderations.  Given the low response rate for correspondence exams, that there are any no-change audits is stunning to me.  At any rate, the IRS spent resources forcing 28,000 people – 12% of all TY 2018 EITC audit closures! — to produce documentation of eligibility, when they were eligible all along.

These numbers are all the more outrageous when you consider the fact that the dollar amount of EITC improper payments are only $16 billion or 3.6% of the IRS’s current $441 billion gross tax gap estimate.  (It is only 1.6 % if you buy the Commissioner’s $1 trillion tax gap estimate, which I don’t).  Why would the IRS focus so much on low income taxpayers?  Certainly, the fact that EITC is subject to improper payment reporting requires the IRS to audit some EITC returns.  But the requirement to audit some returns is not a justification for adopting an assembly-line approach to the most low-income taxpayers.  Could it possibly be the IRS uses that approach because it beefs up the overall audit coverage rate and the number of audits, at really low cost?

Now comes the National Taxpayer Advocate’s 2021 Annual Report to Congress, with its 9th Most Serious Problem focusing on Correspondence Exams.  Let’s take a look at some of the data (relating to FY 2019) presented in the report: 

  • 53% of individual (IMF) audits were on taxpayers with Total Positive Income (TPI) under $50,000. Of this 53%, 82% of the taxpayers claimed refundable credits including the EITC.  (TPI includes “only total positive income values from wages, interest, dividends, other income, distributions, Schedule C net profits, and Schedule F net profits.  Losses are treated as zero.”  MSP #9, endnote 7.)
  • 92% of IMF audits on taxpayers with TPI under $50,000 were conducted by correspondence exam. 
  • The average direct time spent by an IRS auditor on a correspondence exam for taxpayers with TPI under $50k was 2 hours, compared to 11 hours for office exam and 41 hours for field exam.
  • 4% of Wage & Investment Division correspondence exam resources was spent answering phone calls; 96% was spent on handling correspondence.  The Level of Service on the correspondence exam line was 40.7% (Note that this is for 2019, so it is pre-pandemic ….)
  • 35% of 361,000 IMF audits closed in FY 19 for taxpayers with TPI under $50,000 were the result of no taxpayer participation, of which 14% involved undeliverable mail.
  • Unlike field auditors, who can use both internal and external sources, including USPS trace, to locate better addresses, correspondence examiners can only use internal sources.
  • Only 3% of taxpayers with TPI under $50,000 were represented in correspondence audits.
  • Of the 24,700 petitions to Tax Court in FY 19, 17,700 originated in correspondence exam.
  • 94% of audit reconsiderations originated in correspondence exam; 44% of these original audits closed because there was either no record of a taxpayer response or IRS correspondence was undeliverable.
  • 88,000 of taxpayers audited in FY 19 with TPI under $50,000 were placed in collection; 45% of these were in Currently Not Collectible-Hardship status as of 10/28/21.

So.  The primary method of auditing low income individual taxpayers is by correspondence.  If you are more affluent, you are more likely to have a single auditor assigned to your case in office or field exam, but not if you are low income – i.e., in correspondence exam, no one employee is assigned to your case.  If you are more affluent, the IRS is more likely to spend more time looking at your documentation, and communicating with you.  Not so if you are low income.  If you are more affluent, the IRS makes more of an effort to actually locate a more current address if mail is returned undeliverable.  Not so if you are low income.

It’s not just that mail is undeliverable.  IRS audit notices are incomprehensible to taxpayers.  In 2007, the Taxpayer Advocate Service did a survey of a representative sample of taxpayers who had been audited about their EITC claims.  More than 25 % of those taxpayers said they did not understand from the initial letter that they were under audit.  More than 70% said the audit letter was difficult to understand, including they did not understand what documentation the IRS wanted them to provide.  If you don’t understand you are under audit, that will affect your response.  And if you don’t understand what you should send in to prove your eligibility, that will affect your audit outcome.

And in fact, we see this in the no-response and agreed rates of audits of low income taxpayers versus more affluent ones, who are more likely to have a single auditor assigned to the case.  Here’s a chart from the 2021 Annual Report to Congress:

To make matters worse, past TAS studies have compellingly shown that correspondence exam procedures actively harm taxpayers.  In 2012 TAS reviewed a representative sample of taxpayers whose EITC claims were disallowed in correspondence exam and later conceded in full by Chief Counsel when the taxpayer filed a United States Tax Court petition.  In that study we found that these taxpayers, on average, contacted the IRS five times during the audit (one taxpayer contacted the IRS 21 times!).  78 % were ultimately able to submit documentation that was accepted by IRS appeals officers or counsel attorneys after the Tax Court petition was filed.  In 20% of those cases, appeals/counsel accepted documented that IRS auditors had rejected. 

Correspondence exams have been a recurring topic in the Annual Reports to Congress when I was the National Taxpayer Advocate.  At a quick glance, I found Most Serious Problems on various aspects of correspondence exam in Annual Reports from 2001 (my first), 2002, 2003, 2005, 2006, 2007, 2008, 2009, 2011, 2013, 2014, 2015, 2016, 2018, 2019, and 2020.  (My recollection is, in the years we didn’t write about some aspect of correspondence exam, we were just tired of it and decided to give it a rest for one year.)  TAS has conducted numerous research studies on the topic.  And yet the IRS response has been unchanged over the years.

Why does the IRS persist in believing correspondence exam is an efficient, cost-effective method of auditing?  First of all, because it defines efficiency and cost-effectiveness from the IRS perspective – that is, correspondence exam works for the IRS.  It doesn’t have to dedicate (human) resources to the task; it can churn out a lot of audits and get a lot of assessments, all of which feed into its reports of audit coverage and enforcement results.

In fact, correspondence exams are a classic example of IRS assessing efficiency from a superficial cost-benefit analysis, disregarding the administrative burden these exams impose on taxpayers, especially low income taxpayers.  As Les, Keith and I discuss in an upcoming article, the learning, compliance, and psychological burdens of an administrative process can significantly undermine the policy goals of a program, and can even be used to deliberately deter eligible taxpayers from benefitting from a program.

In this blog post, we’ve seen that IRS intransigence over years regarding the correspondence exam process has created a procedural justice nightmare for taxpayers, especially low income ones, as well as generating lots of unnecessary and expensive downstream work for itself.  In part 2 of this “How Did We Get Here?,” I’ll discuss some recommendations for fixing this mess.

Filed Under: Center For Taxpayer Rights, Exam, Taxpayer advocate

January 2022 Digest

February 1, 2022 by 2 Comments

A lot has happened in the tax world since the year began, then filing season began last week, and the ABA Tax Section 2022 Virtual Midyear Meeting began yesterday. There are no signs that things will slow down soon, except for (maybe) IRS notices.

Procedurally Taxing will continually provide comprehensive updates and information, but if you fall behind with your reading or struggle to keep up- I’ll be digesting each month’s posts from here on out.

January’s posts highlighted the NTA’s Report, the ongoing impact of the pandemic, and recent Circuit splits.

National Taxpayer Advocate’s Report

NTA Report Released: Essential Reading: The Report is available and contains new features, including an enhanced summary of the Ten Most Serious Problems and a change in the methodology used to determine the Most Litigated Issues.

What are the Most Litigated Issues and What’s Happening in Collection?: A closer look at the Most Litigated Issues. EITC issues are often petitioned but rarely result in an opinion, suggesting that most are settled before trial. In Collection, lien cases referred to the DOJ have declined substantially over the years corresponding with the decline in Revenue Officers and resources.

Who Settles Cases – Appeals or Counsel (and Why?): An analysis of data on the number of Tax Court cases settled by Appeals or Counsel. An increasing percentage of settlements are handled by Counsel, but why? Possible reasons and possible solutions are considered.

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Where Have Tax Court Deficiency Cases Come from in the Past Decade?: Most deficiency cases have come from correspondence exams of low- and middle-income pro se taxpayers. The focus of IRS examinations over the past decade has influenced the cases that end up in Tax Court. A shift in focus may be coming as IRS seeks to hire attorneys to specifically combat syndicated conservation easements, abusive micro-captive insurance arrangements and other tax schemes.

The Melt – Cases That Drop Away in Tax Court: Around 20% of Tax Court cases get dismissed each year- likely due, in part, to untimely filed petitions. Also due to a failure to prosecute, that is the petitioner abandoned the process somewhere along the way. Ways to address this issue are worth exploring, such as increasing access to representation and implementing a model utilized by the Veterans Court of Appeals.

Supreme Court Updates and Information

Who Qualifies as Press and the Boechler Supreme Court Argument Today: Being consider a member of the press comes with benefits, including the option to attend Supreme Court arguments with a press day pass when Covid-restrictions end. In lieu of being there in person, real-time broadcast links of Oral Arguments are made available on the Supreme Court website.

Transcript of Boechler Oral Argument: A link to the transcript of the Boechler Oral Argument is provided and Keith shares his in-person experiences observing the Supreme Court and the options available to others who are interested in doing so when Covid-restrictions end.

Pandemic-Related Considerations

Refund Claims and Section 7508A: A well-informed analysis of the disaster area suspensions under section 7508A and the refund lookback limits. Does the language in section 7508A allow for an extended lookback period? The IRS Office of Chief Counsel doesn’t think so, but TAS has recommended that Congress amend section 6511(b)(2)(A) for that purpose, and there is an argument that a regulatory solution is already available.

 Making Additional Work for Yourself and Others: The IRS has been cashing taxpayer payments without acknowledging receipt of the associated return. This improper recordkeeping resulted in the IRS sending CP80 notices to taxpayers requesting duplicate returns. This created more work for the IRS, practitioners, and clients. The IRS, however, recently announced it would stop doing this, as summarized directly below.

IRS Announces Stoppage of Notice to Paper Filers Who Remitted Payment and Tax Court Announces Continued Zooming: The IRS will stop requesting duplicate returns from paper filers who remitted payments with their original returns. Members of Congress also made specific requests to the IRS with the goal of providing relief to taxpayers until the IRS backlog is resolved, including temporarily halting automated collections, among other things. The Tax Court announced all February trial sessions will be by Zoom.

Practice and Procedure Considerations

“But I’ve Always Done It That Way!” Practitioner Considerations on Subsequent Year Exams: A TIGTA recommended change to IRS procedure may increase the audit risk for taxpayers who do not respond to audit notices. There is no blanket prohibition on telling clients about audit rates and general likelihoods of audit, so practitioners should be able to advise their clients of this potentially emerging risk and ways to avoid it.

New Rules in Effect for Refund Claims For Section 41 Research Credits Raise A Number of Procedural Issues: New rules for research credit refund claims require extensive documentation which increases costs and the risk of a deficient claim determination. Procedures for determinations were issued at the beginning of the month and have generated concern among practitioners because a determination cannot be challenged with a traditional refund suit and because the IRS modified regulatory requirements without utilizing formal notice and comment procedures.

Tax Court News

Tax Court Going Remote for the Remainder of January[and February]: January calendars (and now February, as mentioned above) scheduled in-person sessions have switched to remote sessions due to ongoing Covid-concerns.

Tax Court Orders and Decisions

The Tacit Consent Doctrine May Extend Far Beyond Signing a Joint Return: The Court in Soni v. Commissioner, allowed the tacit consent doctrine (where facts and circumstances led to finding of consent on the part of a non-signing spouse) to apply to returns, power of attorney authorizations and forms 872. The doctrine could be expanded in future cases, so it should be kept in mind when representing innocent spouses.

Timely TFRP Appeal?: The administrative 60-day deadline to respond to TFRP notices is discussed in an order requesting that the IRS supplement its motion for summary judgment. The origin of a deadline is important. Jurisdictional deadlines are different from administrative deadlines, and cases involving administrative deadlines can be reviewed for abuse of discretion.

Circuit Court Decisions

Eleventh Circuit finds Regulation Invalid under APA: The Eleventh Circuit, in Hewitt, calls into question who has the burden to show that a comment made during a notice and comment period: 1) was significant, and 2) consideration of it was adequate. The Tax Courts says it’s the taxpayer, the Eleventh Circuit says it’s the IRS, but what does this mean for everyone else?

The Fifth Circuit Parts Ways with the Ninth Circuit Regarding the Non-Willful FBAR Penalty: A difference in statutory interpretation results in a recent split between the Ninth and Fifth Circuits over whether the non-willful penalty under section 5321(a)(5)(A) should be assessed on a per-form or per-account basis. The Ninth Circuit held that legislative history, purpose, and fairness support a per-form penalty, but the Fifth Circuit held that Congress’ intent and the objective of the penalty support a finding that it’s per-account.

Goldring is Back with a Circuit Split: The Fifth Circuit addresses how underpayment interest should be computed on a later assessed deficiency when a taxpayer elects to credit forward an overpayment from an earlier filed return. It held “a taxpayer is liable for interest only when the Government does not have the use of money it is lawfully due.” This contrasts with other Circuits which have decided that the law allows the IRS to begin computing interest when an amount is “due and unpaid.”

Polselli v US: Circuit Split on Notice Rules for Summonses to Aid Collection: A recent Sixth Circuit decision continues a circuit split on a fundamental issue in IRS summons practice: does the IRS have to give notice when it issues a summons on accounts owned by third parties in the aid of collecting an assessed tax? The Sixth, Seventh and Tenth Circuits read section 7609 notice requirements and its exclusion without limitations, which contrasts with the Ninth Circuit’s more narrow interpretation.

D.C. Circuit Narrows Tax Court Whistleblower Award Jurisdiction: The D.C. Circuit overturns Tax Court precedent by holding that the Tax Court lacks jurisdiction over appeals of threshold rejections of whistleblower requests. Since all appeals of whistleblower cases go to the D.C. Circuit, the Tax Court is bound by the decision unless the Supreme Court takes up the issue. 

Liens and Judgments

Local Taxes and the Federal Tax Lien: The effect of the Tax Lien Act of 1966 was reiterated in United States v. Tilley.  Section 6323(a) sets up the first in time rule of law, but 6323(b) provides ten exceptions, including one for local property taxes, which allows a local lien to defeat a federal tax lien even when the local lien comes later in time.

Tax Judgments and Quiet Titles: Tax judgments can benefit the IRS beyond the 10-year federal collection statute of limitations. Boykin v. United States, like Tilley, involves real property held by nominal owners. The taxpayer brought suit to quiet title, the IRS counterclaimed that the money used to purchase the property was fraudulently transferred, and the taxpayer argued that a state statute of limitations prevented the IRS’s argument. The Boykin Court disagreed with the taxpayer relying upon Supreme Court precedent that state statutes do not override controlling federal statutes.

Bankruptcy and Taxes

Diving Beneath the Surface of In re Webb: An in-depth analysis of a technical bankruptcy issue that can impact taxes involving an election under section 1305, which allows postpetition tax claims to be deemed prepetition claims. The classification of the claims impacts whether a subsequent IRS refund offset violates a debtor’s rights.

Filed Under: Administrative Procedure Act (APA), Appeals, Bank Secrecy Act, Burden of Proof, Collection Due Process, Earned Income Credit, Equitable tolling, Exam, FBAR, Form 2848, Innocent Spouse, Interest, Judgment, Lien, Monthly Digest, Overpayment Interest, SCOTUS, Statutes of Limitation, Taxpayer advocate

Where Have Tax Court Deficiency Cases Come from in the Past Decade?

January 28, 2022 by 1 Comment

Almost 95% of the cases in Tax Court involve deficiency procedures.  You can see the Court’s description of the numbers and kinds of cases it receives here on p. 21.  The National Taxpayer Advocate’s annual report provides a look at where the deficiency cases have come from over the past several years in a chart from page 198 of that report.  Here it is:

It comes as no big surprise that the bulk of Tax Court cases come from Correspondence Examination, which means that the bulk of Tax Court cases are from low or lower middle-income taxpayers, which means that the bulk of Tax Court petitioners are pro se.  Another graph the NTA displayed in her report shows this very well.  See here:

Looking at the chart about the types of cases that come to Tax Court also allows you to see that when the recent blog post showed that Appeals’ percentage of settled cases is declining, this means that it is failing to settle the cases of low income taxpayers.

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There could be multiple reasons for that, not all of which have anything to do with the effectiveness of Appeals.  Low income taxpayers may be less likely to settle cases because they don’t know how to use the system to its fullest and also don’t know whether something is a good settlement or not.  Appeals may also be uncomfortable settling cases that will heavily turn on the testimony and the credibility of a witness they cannot see across the table.  As the mix of cases is skewing more and more to the lowest income, least represented segment of the population, Appeals has struggled to keep up its settlement numbers.

There is a tight correlation between the types of people the IRS examines and the cases that come to the Tax Court.  This is not a news flash.  I witnessed a huge swing in the types of cases coming into a field office in Chief Counsel during my three decades.  Undoubtedly, the mix of cases will continue to change as the IRS prioritizes different work and as Congress passes laws or provides funding that also change priorities and possibilities.  Related to this, see the recent announcement from Chief Counsel that signals a possible big shift in the cases it will work:

Issue Number:    IR-2022-17

Inside This Issue

IRS Chief Counsel looking for 200 experienced attorneys to focus on abusive tax deals; job openings posted

WASHINGTON – The Internal Revenue Service’s Office of Chief Counsel today announced plans to hire up to 200 additional attorneys to help the agency combat syndicated conservation easements, abusive micro-captive insurance arrangements and other tax schemes.

“Combating abusive tax transactions that threaten to undermine our tax system remains a top priority for our enforcement efforts,” said IRS Commissioner Chuck Rettig. “It’s critical we work to ensure a fair tax system and adding these new attorneys will help us in on our ongoing efforts in this arena.”

These positions will be available around the country, and the IRS encourages qualified candidates to apply. The first announcements for these positions have already been posted on USAJOBS. Interested persons should apply today or as soon as possible via the following announcements:

– Large Business & International Positions:  USAJOBS – LB&I Attorney Announcement

– Small Business/Self Employed Positions:  USAJOBS – SB/SE Attorney Announcement

– Technical Positions:  USAJOBS – Technical Job Announcement

Promoters have been particularly active developing and marketing tax shelter schemes that purportedly enable taxpayers to avoid paying what they legally owe. These new hires will help the IRS manage the increasing caseload in its multi-year effort to stamp out these abusive schemes and ensure that those participating in them pay the tax they owe plus penalties.

“This is an excellent opportunity for attorneys with experience in litigation, partnership tax law and planning complex transactions to join the Office of Chief Counsel and make a real difference for our tax system,” said Principal Deputy Chief Counsel William M. Paul.

These positions will be available in more than 50 locations, including Washington D.C. Those hired will provide legal advice to IRS professionals as they conduct audits of complex corporate and partnership issues and increasingly sophisticated and abusive transactions. The Chief Counsel office, working closely with IRS and the Treasury Department, provides world-class litigation and substantive tax training for all experience levels.

New hires will work in a variety of areas, including handling cases in the United States Tax Court, as well as serving on trial teams in our largest and most complex trials involving fact and expert witnesses, depositions and multi-week trials. They will also work with the Department of Justice Tax Division, which handles refund cases in district courts and the Court of Federal Claims.

Others hired will serve in the IRS national office with a focus on developing global regulatory solutions to the most sophisticated and abusive transactions and providing highly specialized advice to IRS litigation teams.

Abusive syndicated conservation easement deals remain a major focus for the IRS. These transactions generally use inflated appraisals of undeveloped land and partnerships devoid of legitimate business purpose designed to generate inflated and unwarranted tax deductions.

“Bogus syndicated conservation easement transactions undermine the public’s trust in private land conservation and defraud the government,” Rettig said. “Putting an end to these schemes is imperative.”

Abusive micro-captive insurance arrangements also remain a key focus of IRS enforcement. These deals are generally sold to owners of closely held entities. The deals commonly lack many of the necessary attributes of insurance, have excessive premiums, insure highly improbable risks and have no connection to genuine business and insurance needs.

These are just some of the abusive schemes that the new hires will be working on.

Paul noted that there are numerous advantages to joining Chief Counsel. The Office of Chief Counsel has successfully transitioned in response to the Covid-19 Pandemic. Chief Counsel is currently in full telework mode and will have a competitive telework policy going forward.

To learn more about these opportunities, visit IRS Office of Chief Counsel | IRS Careers. The mission of the Office of Chief Counsel is to serve America’s taxpayers fairly and with integrity by providing correct and impartial interpretation of the Internal Revenue laws and the highest quality legal advice and representation for the Internal Revenue Service.

Filed Under: Exam, Tax Court

“But I’ve Always Done It That Way!” Practitioner Considerations on Subsequent Year Exams

January 11, 2022 by 2 Comments

Stop me if you’ve heard this one. A taxpayer and a tax attorney walk into a room. The taxpayer pulls out an IRS examination letter and says, “I’ve always filed my returns this way, and the IRS has never cared in the other years. Why is the IRS suddenly out to get me?” The tax attorney looks at the return and the letter. “Ah. The answer is simple: You’ve always filed your returns wrong. This is just the first time the IRS has noticed.”

And everyone in the room shares a good laugh.

Or, more likely, the tax attorney begins shifting uncomfortably in their seat the moment they see the problem -specifically, that there are a lot of erroneous returns filed by your client that have not been caught and may realistically never be. The obligation (or lack thereof) to file an amended return to fix errors has previously been covered by Keith (co-author: Calvin Johnson) in an article here. In a different context, I have written about when you do or do not have an obligation to correct IRS mistakes here and here.

In this post I’d like to take the conversation in a slightly different direction. Specifically, I want to wrestle with the issue of advising clients on exposure to future audits -a thorny topic in the tax community.  

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In my most recent post I covered a TIGTA report suggesting improvements to correspondence examinations, prompting my own suggestions to focus more on high-income earners and non-filers. That same TIGTA report included a raft of recommendations for examining taxpayers that appear to have the same tax issue over multiple years (“subsequent year exams”). Those recommendations are what caught my eye and inspired this post.

TIGTA’s concerns were that the IRS didn’t appear to be initiating as many subsequent year exams as it should, and the IRS could increase efficiency by considering subsequent year returns as part of the already open exam. In a nutshell, TIGTA’s recommendations hinged on the idea that if a taxpayer erroneously claimed a deduction/took a credit in one year, there is a good chance that the same deduction/credit is erroneous in the next year as well. And I’d say that is a fair assumption. But it carries some interesting considerations that I believe tax practitioners should be aware of.

The recommendations put forth by TIGTA were more narrowly focused than just increasing audits on those that have been audited already. For one, it pertained only to subsequent returns with the same issue identified as in the year audited (the same “project code”). Second, it focused on taxpayers that actually resulted in an increased assessment of tax, thereby filtering out those who were selected for exam but ultimately demonstrated that their return was correct. Third, and importantly, TIGTA particularly keyed-in on subsequent returns where the taxpayer defaulted – that is, where they never responded to the exam in the open year and had similar identified issues in subsequent years.

“Silence is Violence”

A key takeaway from this may be that when the IRS selects you for examination, generally the worst thing you can do is to do nothing at all. The TIGTA recommendation (which IRS management agreed with) is to “change the subsequent return process to address only subsequent year returns in which the taxpayer did not respond to the [Initial Contact Letter] for the current examination.” Page 12 of the TIGTA Report (emphasis added).

In other words, if you don’t do anything (or don’t respond to the very first letter) it may carry worse consequences than if you respond with a full concession owning up to your error. Apart from just doing the “right thing,” it may be in your self-interest to proactively agree with the IRS rather than just letting things run their course.

Note also that the IRS also has internal policies against “repetitive” audits. They are a bit narrow (I covered an unsuccessful attempt to raise the policy in court here) and don’t apply to Schedule C returns (even though the prohibition is explicitly mentioned on the IRS Publication for Schedule C Filers: Pub. 334, page 45). However, whatever protections the policy does offer are more likely to apply when the taxpayer actually responds to the audit. See IRM 4.10.2.13.2.

All of this taken together, I think, should factor into any advice that is given to a client. I think it is important to impart the wisdom you’ve gleaned as a practitioner on the black-box of audit: “if you don’t respond to the IRS letter, there may be a heightened possibility that you will be audited on subsequent years.” If I was the average taxpayer that is definitely something I’d want to know and take into consideration.

The Audit Lottery

And now, the backlash.

“You can’t advise your client on the likelihood of audit!” Chants of “audit lottery!” and “Circular 230!” drum in the background as the torches are lit. My demise (the stripping of my ability to practice before the Service) is nigh.

Or so it would seem. But only based on a misunderstanding of what prohibited advice about audit likelihood actually entails. When I talk to (or test) my students about the “audit lottery” some take that it to mean you cannot talk to a client about audit risks. Period. In this understanding, when a tax lawyer reads the (publicly available) IRS Stat Book and sees the (abysmal) exam rate, that knowledge is forbidden fruit. One must never utter a word of it to the innocent, untainted client.

This misunderstanding of the audit lottery is not limited to students. There is, in fact, enough confusion about the topic that Professors Michael Lang and Jay Soled wrote a helpful article in the Virginia Tax Review on it here.

To be clear, there is no blanket prohibition on telling clients about audit rates and general likelihoods of audit. Consider the absurdity and inability to effectively counsel or communicate, while meeting the requirements of the MPRC (specifically MRPC 1.4) if such a blanket prohibition did apply. As an example:

I frequently have clients where the problem is that their ex claimed a child of theirs. The client is the custodial parent and has the right to claim their child under IRC § 152. However, the ex was first in the race to the e-file button. Because of this, any subsequent attempt to claim the child (generally through a paper return) will very likely trigger an exam. I know this both from experience as a tax practitioner and because of my familiarity with “whipsaw” and “correlative US Taxpayer” procedures. See IRM 4.10.13.5.

Am I not allowed to tell my client that if they do file a paper return claiming the child they are at a high risk of audit?

Believe it or not, audit exposure is something that matters to clients even when they are 100% substantively right on the return position. Some of my clients simply would rather not deal with the IRS or, importantly, the ire of their ex. Similarly, I know of a few people that claim a smaller charitable deduction than they actually are entitled to solely because of their (inflated, inaccurate) fear of audit. It is wholly within these taxpayers’ right to make that determination, since they are not legally required to claim the child or the charitable contribution, but only have the right to do so. For a discussion on that point, see the law review article, “No Thanks, Uncle Sam, You Can Keep Your Tax Break.”

So in advising the client with a previously claimed child, what must I do? As a lawyer and as a counselor, I would go so far as to say under the Model Rules I must disclose the risk of audit to the client in that situation, rather than keep it stored away as secret knowledge. To me, a lawyer in that situation should advise the client that on the information they have: the client is entitled to claim their child if they wish, but they are at a heightened risk if they do so. The lawyer should then calm the client down and explain what an audit would actually look like in these circumstances (a few letters back and forth), so that they can make an informed decision about what they’d like to do. To me, getting the client to a more-fully informed decision considering the myriad legal and non-legal issues at hand is the bedrock of being a counselor. See MPRC 2.1.

All of this is to say that one does not “play” the audit lottery simply by speaking of or considering audit likelihood. The prohibition is on advising individuals to take a return position based on the likelihood that it might be “caught” in audit. You play a lottery hoping you win, not simply for the fun of playing. Winning, in the prohibited sense, is having a questionable (or crazy) return position pass by the IRS because of their low audit rates rather than the merits. And you cannot let your knowledge of the odds of success (in this case, the perversely high chance of winning the lottery) color your responsibilities towards the IRS. See, e.g. Circ. 230 § 10.22, 10.34 and 10.37.

Now, rant completed, let’s bring this back to advising someone as to whether they should respond to an IRS letter after an audit has been initiated. In this case you are not counseling them on prospectively taking a return position at all. If they’ve made that same mistake year-over-year, the position has already been taken before they even came to you. What you are doing is simply letting them know that failing to respond to an IRS audit might make future audits more likely. If that is true (and there is reason to believe it is), it is unclear to me how keeping that important information to yourself doesn’t run afoul of your many responsibilities to the client under the MPRC (loyalty and communication, foremost among them).

I want to close with a note to those feeling squeamish about the preceding paragraphs: I feel your pain. If someone has previously taken an incorrect tax position I counsel them to change it. I want them, genuinely, to change it, because I believe we all have an obligation to pay the correct amount of tax. However, I cannot tell them that they must change it, because that would be my imposing my own personal morality on a legal question that has different considerations. (Note that this all changes if and when there is an actual controversy for that tax year before the IRS.)

But there is more to this than just hand wringing and pleading that someone do the right thing while acknowledging they don’t technically have to. Once the taxpayer knows (through the counseling of their tax attorney) their position is untenable they cannot freely take that position in as-yet unfiled tax years. Now, your advice changes: “Look, you should fix the back years, but you don’t technically have to. However, now that you know those positions are wrong, you cannot take them moving forwards and if you do there could be criminal exposure.”

Thus, the tax attorney sleeps at night.

Filed Under: Exam

Memoirs of the Last Century: Some Notes on Economic Reality and Section 7602(e)

November 3, 2021 by 1 Comment

We welcome back Bob Kamman who writes today about the past and how it matters in having a full understanding of the current debate forbidding the use of financial status or economic reality examination techniques.  Like Bob, I remember when the IRS rolled out economic audits.  His remembrances and insights help inform the current debate.

Les and I will be working with the Pittsburgh Tax Review to create a special edition on RRA 98 for its 25th birthday.  Maybe this will become one of the resources Bob seeks for Caleb’s students.  We welcome stories and comments from others who remember the lead up to that memorable tax procedure legislation.  Keith

In two recent posts available here and here, Professor Caleb Smith has discussed the current status and future implications of Code Section 7602(e), which forbids the use of “financial status or economic reality examination techniques” unless there is a “reasonable indication that there is a likelihood of unreported income.” 

Whatever that means.

The prohibition was part of the IRS Restructuring and Reform Act of 1998, and therefore has been law during all of Professor Smith’s professional career.  I am sure he knows much of the history behind RRA98, but are there resources for explaining its meaning to his students?

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Allow me to reminisce about the events of 27 years ago, because a page of history may be worth a volume of statutory analysis.  I was there.  In fact, I was among the first to see it coming.

The first mention I encountered of “lifestyle audits” was at a regional gathering of 400 tax practitioners in Ogden, Utah in September, 1994.  We had been invited to seminars and a rare tour of the Service Center by former IRS Assistant Commissioner Robert Terry, who had stepped down from his position in Washington to become Director of that facility in his home state. Commissioner Margaret Milner Richardson was a keynote speaker.  (I asked her when IRS would implement the long-promised program of providing a PTIN so that preparers would not have to enter their SSN on every return they prepared.  She had no idea what I was talking about.)

The details on “Economic Reality” audits, meanwhile, came from John Monaco, the IRS Assistant Commissioner for Examination.  I wrote about it in an article for the November 1994 edition of “Tax Savings Report.”  From that article:

Every IRS auditor is going back to school for a week this Fall to learn a radical new approach to the job.

For years, IRS auditors have focused on paper and numbers – tax returns and the entries on them.  Now, auditors are being told to take a closer look at individual taxpayers using the increased capacity of computer matching.  When they see the whole picture, they ask, “What’s wrong with it?”

In an Economic Reality audit, inquiring minds at the IRS want to know:

– Your net worth.  Has it grown over a period of years due to hidden income?

– Your lifestyle, and especially your personal living expenses.  Do you indulge champagne tastes, when your Form 1040 shows a beer budget?

– How you make a living.  The IRS will pay attention to typical ways it has caught others in the same business who understate income or exaggerate deductions.

Auditors will go into an Economic Reality examination armed with data assembled through improved computer technology. [They] will already know whether you live in an affluent neighborhood and how much your car is worth.

Will the public approve of this increased interest by the federal government in private financial affairs?  Privacy concerns have to be addressed, acknowledged [Monaco], in a recent presentation to tax preparers on Economic Reality.

“You don’t get into these questions until there is an indication of unreported cash.  Most of the public demands that we do it,” Monaco said. “What else do you do when you see someone buy a $100,000 boat, and support a family of four in a wealthy neighborhood, on a reported income of $20,000 for each of the last three years?”

In IRS field tests, Monaco said, Economic Reality has succeeded.  When confronted with questions concerning their lifestyle and net worth, taxpayers readily signed agreements to pay more tax.  “Our problem is deciding how many to refer for criminal investigation, and how many stay as civil matters only,” Monaco said.

And one local audit manager pointed out that Economic Reality can occasionally benefit a taxpayer, too.  One planned audit was canceled when a three-year review of a computer business showed that, after early profits from a software product, it became obsolete, and the taxpayer lived on savings and pursued unprofitable ventures.

To refine safeguards against auditors being too aggressive, the IRS has also scheduled them for follow-up training sessions, of two to four hours, every two weeks after the basic Economic Reality boot camp.

“If we’re not careful how we do it,” Monaco said, “we won’t be doing it for very long.  That’s when Congress will add provisions to the Taxpayer Bill of Rights.”

Four years before RRA98, he was certainly prophetic.

The newsletter editor Ellen M. Katz wanted to make sure that I had this scoop right, so she did some fact checking herself.

We asked IRS spokesman Wilson Fadely to describe the new “Economic Reality” audit program.  His reply:

“An auditor will no longer just say ‘let me see your canceled checks or cash journal.’ We’ll be looking at it a different way, by examining whether the tax return fits the economic situation.  Now, we’ll ask questions, like: ‘Are there very large interest payments or large mortgage payments and not much income?  If so, something is not right.  A lot of agents have been doing this for years.  But now the practice will be institutionalized and put in the training program for auditors to follow.”

In June 1995, I followed up with a newsletter article after trying to get more information on the program.  The IRS was beginning to sense the public was uncomfortable.  So I wrote:

When IRS Commissioner Margaret Milner Richardson was asked recently about the new audit methods that investigate taxpayer lifestyles, she shrugged off the major policy change as nothing innovative. 

“It’s the same technique we used on Al Capone” she said in a PBS interview.  So now, with the help of the auditing technique called “Economic Reality,” American citizens in the 1990s can be treated like Chicago mobsters of the 1930s.

But today, it only takes a few strokes of a computer keyboard for IRS to yield vast amounts of personal financial data on a targeted taxpayer.  “The IRS ‘culture’ as to how audits are done is changing and the ‘culture’ of our clients is also changing,” according to the training material the IRS uses to teach auditors about the new program.  The materials were released by the tax agency under a Freedom of Information Act request, but they were not obtained easily. 

In September, a FOIA request was submitted for Tax Savings Report.  Such requests are supposed to be filled in thirty days, and often are.  Five months later, after repeated letters and phone calls, IRS finally sent part of the materials.

IRS auditors learning how to conduct “Economic Reality” audits are told that “to be effective, we need to adapt” to the changing culture.  They are told to discuss various topics, including the following subjects, but the training materials do not elaborate on what should be said:

– Diversity

– Respect for Government Authority

– Influx of Immigrants

– Emphasis on Expeditious Closing (how quickly an audit is completed)

– Aggressive vs. Kinder/Gentler (approach toward taxpayers).

Auditors learn that Economic Reality “finds meaning through a process of gathering information about a taxpayer,” and “is built upon a universe of financial information about the taxpayer and their lifestyle.”  In a later session, auditors learn “to develop a picture, or profile of the taxpayer’s lifestyle and its cost.  The process is designed to compare lifestyle cost with available resources and to alert you to inconsistencies.”

Shortly after my first article was published in November 1994, the Washington Post picked up on the story.  Noted Washington Post financial writer Albert Crenshaw, in a story syndicated to other newspapers, wrote:

After years of checking W-2s and 1099s and making sure that taxpayers have receipts for their deductions, the Internal Revenue Service is adding a new weapon to its audit arsenal.  It’s called “economic reality,” and it means that IRS agents are going to start looking beyond the numbers of the return to make sure the report jibes with the taxpayer’s assets and lifestyle.” …. The agency already has begun training auditors in “economic reality” techniques, and agents will be expected to implement them as soon as they complete the course. 

IRS officials say the training includes a heavy emphasis on privacy and ethics, designed to make sure taxpayers’ rights are protected.  Nonetheless, some experts and a number of the agency’s regular critics are voicing concern.

Crenshaw’s article finished with a quote.  “This represents a fundamental shift in the philosophy behind audits,” said Pete Sepp of the National Taxpayers Union.  NTU was the publisher of the Tax Savings Report newsletter.

Later that month, financial columnist Kathy Kristof of the Los Angeles Times also reported the latest news about tax audits:

…[IRS] just launched an auditing initiative called economic reality, an expanded and improved method of nabbing people who understate their incomes.

…When these folks get audited, they’ll also find that the IRS is not focusing completely on their tax returns.  Through the wonders of computer matching, IRS agents can find out if you own a boat, a plane or a luxury car.  They can determine the size of your mortgage.  And they can subpoena your bank records to find out just how much money is going in and out of your accounts, says Bob Kamman, a Phoenix tax accountant.

(Journalists sometimes have a problem with identifying me as a lawyer.)

It wasn’t until July 28, 1996 that the New York Times discovered the issue. The story by Barbara Whitaker led with an anecdote:

When an Internal Revenue Service agent said she wanted to audit Dave and Lucille Miller’s 1993 and 1994 tax returns, the couple thought it sounded like a simple thing.

“She called my wife, asked her a few questions and said, ‘Well, you seem to be pretty well in the know of what’s going on,’ ” said Mr. Miller, an auto salvage dealer in Clearwater, Minn. ” ‘Maybe we’ll just sit down at the kitchen table and hash this out.’ “

They hashed it out for a month and never once made it into the kitchen. The meetings, at Mr. Miller’s salvage yard and at his accountant’s office, were a free‑for‑all of questions about expenditures on everything from the most mundane items, like groceries and clothing, to past vacations.

“Can you tell me just off the top of your head how many groceries you bought two years ago?” Mr. Miller asked rhetorically. “How many vacations did you take? Well, what do you call a vacation? If you went away for the weekend?”

At the heart of Mr. Miller’s frustration is what the I.R.S. calls its “financial status auditing technique,” more commonly known as an “economic reality” or “life style” audit. The principle is simple. Rather than just examine a tax return to see that all the items add up, as in a regular audit, revenue agents look at whether the figures mesh with how the person lives. If the taxpayer has a new Mercedes in the garage and declares only $20,000 in income, the I.R.S. would likely raise an eyebrow.

…Anita L. Horn, a spokeswoman for the American Institute of Certified Public Accountants, said her organization had received more than 100 complaints about life‑style audits since September, when the group started keeping track. She said there were complaints about the nature of the questions and about agent demands to interview taxpayers rather than deal with their representatives. The group said the technique often led to drawn‑out audits.

Looking over some of the complaints, Ms. Horn cited a case in which an agent asked what a woman kept in her bedroom drawers. Another taxpayer was asked how much cash was buried in the backyard, and a California couple had to meet with an agent in their home when the woman was on bed rest, eight months pregnant with triplets.

As Professor Smith points out, “financial status or economic reality” audits are not defined by Code Section 7602(e).  Students of tax history, though, should realize that both Congress and IRS knew in 1998 exactly what they were talking about.

Filed Under: Exam, Information Returns Tagged With:

IRC § 7602(e) Will Not Save You (From Bank Information Return Exams)

October 26, 2021 by Leave a Comment

Lately there has been much fury and gnashing of teeth on the Biden administration proposal to vastly increase bank reporting requirements to the IRS. In a nutshell, the proposal would require banks and credit unions to send a year-end information return to the IRS when an individual hits a threshold amount of “inflows and outflows” from their account, or certain other activity (transfers to foreign accounts) takes place. The proposal is in its embryonic stages, but the initial suggestion was that the reporting requirement could be triggered by as little as $600 in annual inflows/outflows. In other words, virtually everyone reading this would have additional information reported to the IRS every year.

Naturally, there are strong opinions about the unprecedented surge of information reporting this would entail. The Treasury provided a pretty bland defense and explanation here at page 88 (more info reporting means less tax gap!). The NYT has covered some of the outrage from banks and privacy-minded individuals here.

But more interesting to me was the technical focus of a Forbes article here quoting an expert from Brookings here. Specifically, what caught my attention was the argument that even if the provision became law the IRS couldn’t really do anything with the information returns because of the IRC § 7602(e) prohibition on “financial status or economic reality examination techniques[.]”

As someone that teaches Federal Tax Procedure, I was aware of IRC § 7602(e). Yet the idea that it would meaningfully constrain the IRS was novel to me. I had to dig deeper…

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The results of my digging, I’m afraid, do not lead me to believe that IRC § 7602(e) provides any robust protections against the use of bank information reporting. My research definitely did not lead me to the conclusion that in 1998 Senator Biden (and essentially all of the rest of Congress) voted to foreclose the use of information by the IRS that President Biden now wants. Let’s take a look at the statute and legislative history to see why.

IRC § 7602(e): Statutory Language and Intent

The statute at issue was enacted as part of the IRS Restructuring and Reform Act of 1998 (“RRA 98”). With the (sometimes overzealous) goal of curbing perceived IRS abuses, RRA 98 enacted a raft of taxpayer protections. Subtitle E of the bill was titled “Protections for Taxpayers Subject to Audit or Collection Activities,” and included Sec. 3412 (present-day IRC § 7602(e)). That code section reads:

(e) Limitation on examination on unreported income

The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.

This may seem fairly straightforward, but it allows for a fair amount of ambiguity. As applied to the potential bank reporting requirement, one might ask what exactly is a “financial status” or “economic reality” examination technique?

Neither term is defined in the tax code, so there is already some wiggle room there. The general understanding, however, is that they pertain to “indirect methods” of proving unreported income. At its simplest, indirect methods are used where there is not a specified “source” of taxable income. If the IRS suspects that you have unreported income but can’t point to a specific source, indirect methods come into play. The IRS might look at the income on a tax return and compare it to some other data (depicting the individual’s “financial status or economic reality”) that strongly suggests there was more income than reported. The most common indirect method that the IRS uses to show unreported income is bank accounts analysis -a method routinely upheld by courts. For purposes of consistency, I will refer to these indirect income audits as “financial status” audits throughout the post.

An information return from a bank showing just inflows and outflows certainly smells like a review of financial status. But does it run afoul of IRC § 7602(e)?

Maybe (it really depends on what the IRS is using the information return for).

But likely not. Let’s hold that thought for a second and look a bit more at the legislative intent behind this statute.

In the words of the Senate (and House) Reports:

“The Committee believes that financial status audit techniques are intrusive, and their use should be limited to situations where the IRS already has indications of unreported income.” See S. Rept. 105-174 and H. Rept. 105-364.

From this terse description we can surmise that the intent wasn’t to eliminate financial status audits, but to limit their use and protect innocent taxpayers from being subject to intrusive IRS requests for information. Again, the IRS can still subject taxpayers to financial status audits, but only where they have some (vague) other indication of unreported income first. What the IRS can’t do is lead with an intrusive financial status audit.

So Would The IRS Be Precluded From Using Bank Information Reports for Examination?

Let’s start with an uncontroversial proposition: the requirement that banks and other third parties provide information returns to the IRS is neither an exam of the bank nor of the taxpayer that the information pertains to. Accordingly, the collection of the information returns from the banks in itself is not a violation of IRC § 7602(e). I think it is equally uncontroversial to say that the IRS using data from these information returns is not in itself an IRC § 7602(e) prohibited “financial status or economic reality examination technique[].” Just using data reported to you can be quite different from conducting a financial status audit.

With this understanding the IRS using bank information returns on file as part of the selection process (but not the determination of unreported income) arguably would not run afoul of IRC § 7602(e). It basically would just be one more number plugged into a DIF score.

The protections of IRC § 7602(e), under this reading, come after the return has been selected and protect against “audit techniques” taking place during the actual (not theoretical) exam. This jives with the language and intent of the statute, since the “selection” for potential exam itself is not particularly intrusive on the taxpayer and the scoring of a return (which doesn’t always or even usually lead to audit) is definitely not an audit “technique.” This is also how I think the information returns would be likely used by the IRS in practice: as part of an algorithm for selecting returns to potentially examine thereafter.

But I can already hear the cries of my detractors. The statute contemplates a prohibition on the processes leading to the determination of the unreported income (i.e. the “examination techniques.”) Isn’t the selection of a return for further examination based on these information returns prohibited as part of the examination, even if an earlier step?

I don’t think that argument is going to win the day.  To me, that argument misunderstands how examinations work in order to give an overly broad sweep of IRC § 7602(e). To better understand, it is helpful to understand when IRC § 7602(e) comes into play under current law.

The Current IRC § 7602(e) Landscape

As detailed in the very informative PT post here, IRC § 7602(e) “puts the brakes on IRS examiners.” Before 1998 the IRS examiner could decide to escalate their review into an intrusive financial status examination on a hunch. Under present procedures (I assume adopted in response to IRC 7602(e)), the examiner must first run through various “minimum income probes” (outlined in the IRM here) before they can even begin to escalate the intrusiveness. Those minimum income probes are what provide the “reasonable indication that there is a likelihood of such unreported income,” which in turn allows or precludes the financial status exam. But if the IRS initiates a financial status examination without running those minimum income probes (or some other method giving them the needed “reasonable indication”) they would be in violation of IRC § 7602(e).

That, at least, was the argument made by Professor David Breen in the PT post linked above. And Prof. Breen would have excellent insight on the subject, having seen the inner machinations of the IRS as a revenue agent, exam group manager, and Chief Counsel attorney for many years.

As far as I can tell, the IRS actually takes a slightly dimmer view of the protections of IRC § 7602(e) than those advanced by Prof. Breen. At least that’s the sense one would get under an IRS memo on the topic. In that memo, the IRS contends that it doesn’t even need to have “reasonable indication” of unreported income before it can initiate a financial status exam. For example, an examiner given a return selected under the “National Research Program” (that is to say, a return selected entirely at random) can still initiate the audit by requesting all sorts of bank account information from the taxpayer. The reason this doesn’t run afoul of IRC § 7602(e) is because at that stage the IRS hasn’t “determined” there is unreported income just yet. Because IRC § 7602(e) only comes into play when there is such a “determination” it would be “premature” for it to apply at this initial stage.

Or so the IRS argues.

There may certainly be policy justifications for why NRP exams should be exempt from IRC § 7602(e). Indeed, it is hard to think of how the NRP would work in collecting statistics as a random, detailed audit without being fairly intrusive. Nonetheless, the IRS memo’s reasoning, I think, is probably wrong (but arguable) under the language of the statute. Let me also just hint (to be covered in my next post), that the remedies against the IRS if they are wrong on that interpretation are probably quite limited. The IRS rationale hinges on the word “determine” which carries a lot of meaning in the administrative law context, but seems to be misapplied in the memo. Either way, for now it suffices to say that the IRS probably wouldn’t be of the opinion that IRC § 7602(e) precludes them from using bank information returns to initiate further examination activities. And I think they’d be right about that.

Again, the cries of my detractors ring out. “You’re putting the cart before the horse here, Caleb. The IRS is using prohibited techniques (financial status/economic reality) the very moment it takes that information and plugs it into the DIF equation, or any other selection method it may come up with. Don’t get bogged down in the minutiae of how examinations actually work. Focus on the fact that the IRS would be using financial status/economic reality information to determine unreported income by baking it into the processes.”

This is certainly the big-picture view of the issue. But it only works by taking the statutory language and converting it into a broad policy it never really contemplated, and which would be essentially unenforceable. More to the point, it requires return selection criteria to be synonymous with “examination techniques.” That is a bridge too far to me, as they are vastly different animals. It goes well beyond both the language of the statute and its legislative intent. Again, I don’t think it would win the day in any court of law.

The Potential Unintended Interplay of IRC 7602(e) and Bank Reporting

Recall the proviso that financial status/economic reality can be used where the IRS “has a reasonable indication that there is a likelihood of such unreported income.” Taking this into consideration, it is possible that increased bank reporting may have the exact opposite effect than that suggested by Forbes/Brookings. It could conceivably allow more financial status/economic reality examinations, because those information returns could provide the IRS a “reasonable indication” of the “likelihood of such unreported income.”

In other words, far from requiring an amendment to IRC § 7602(e) for the bank reporting to have use, the new law could actually weaken whatever protections IRC § 7602(e) currently provides. I’ve been purposefully avoiding the normative question of whether this increased bank reporting is advisable (and especially whether it is advisable for inflows and outflows as low as $600). But I do think that considering its effect on IRC § 7602(e) (rather than the effect of IRC § 7602(e) on the proposal) should also weigh in on the normative question, at least if Congress is still concerned about overly intrusive audits. I get the impression that the current proposal, if it survives at all, is likely to survive in a vastly different form. But no matter what form it takes, I seriously doubt it will be rendered useless under IRC § 7602(e). There could be ways that the IRS goes too far with it, and there could be consequences for the IRS when it does so. But those consequences (and the chance they ever come to fruition) are very likely to be limited. Or so I’ll discuss in my next post.

Filed Under: Exam, Information Returns
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