Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?…Continued!

We welcome back guest blogger Omeed Firouzi, who works as a staff attorney at the Taxpayer Support Clinic at Philadelphia Legal Assistance, for a discussion of the latest case involving an information return with improper information.  The question of how far the statute goes in order to protect recipients continues to play out in the district courts with recipients struggling to gain traction through IRC 7434.  Keith

I, among other tax practitioners, have written on this blog several times about 26 U.S.C. Section 7434. Specifically, we’ve written about the debate in district courts as to whether pure misclassification of an employee as an independent contractor is actionable under Sec. 7434.

A central question in courts’ analysis here is how to interpret the language, “with respect to payments purported to be made to any other person.” § 7434(a). At issue in all these cases, including the one below, is whether willful filing of a fraudulent information return covers only payment amounts themselves or whether it can also encompass misclassification itself.

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On December 1, 2021, the U.S. District Court for the Middle District of Florida, Tampa Division, handed down a decision granting summary judgment in favor of a firm that the plaintiff accused of fraudulent misclassification per Sec. 7434. As such, this court joined the (so far) majority of district courts in ruling that misclassification per se is not actionable under Sec. 7434 (although it was a notable departure from other recent Florida cases).

The case revolves around taxpayer Jen Austin and her experience with Metro Development Group. The case also involved an interesting issue as to whether reimbursed expenses can be included on a Form 1099-NEC and questions of state law. For our purposes though, it is important to look at the relevant 7434 aspect of this case. Austin says she was hired as an employee by Metro in 2014 but then she was actually paid as an independent contractor. Notably, Austin herself formed an LLC (Austin Marketing, LLC) for these 1099 payments though she also alleges she complained several times about her classification to no avail. For his part, the defendant, John Ryan, “testified in his deposition that he did not remember Austin asking to be an employee.” Austin worked for Metro until April 2020; she says she was fired “in a private meeting with Defendant Ryan [but] Ryan claims he never fired her.”

Two months later, Austin and her LLC, Austin Marketing LLC, filed suit against Metro and CEO John Ryan in federal district court. Austin and Austin Marketing, LLC sought, among other claims for relief, damages under Sec. 7434. Though the Court dismissed part of the complaint on the grounds that “Austin was not individually injured by any fraudulent tax standing,” the Court did allow Austin Marketing’s claim to be heard. Ultimately, the defendants moved for summary judgment on the matter of Section 7434, partly “on the basis that misclassification does not give rise to a claim under Sec.7434” – and they won.

In an order written by U.S. District Judge Kathryn Kimball Mizelle, who recently earned national attention with her injunction against the CDC’s federal air and public transit mask mandate order, the Court plainly stated that “only claims for fraudulent amounts of payments may proceed” under Sec. 7434. Judge Mizelle wrote that the plain text of the statute supports this conclusion because “with respect to payments” makes clear that a fraudulent information return must be one that has an incorrect amount on it. Mizelle cites not only U.S. Supreme Court interpretation of the phrase “with respect to,” from an unrelated 2021 case involving the Federal Housing Finance Agency, but also the litany of federal district court cases that also found misclassification per se as outside 7434.

Mizelle also focuses on the next part of the statute, specifically “payments purported to be made.” She writes that the phrase “’payments purported to be made’ clarifies that actionable information returns are ones only where the return fraudulently-that is, inaccurately or misleadingly- reports the amount a payer gave to a payee.” Finally, on this specific matter, Mizelle cites the Liverett case, the Eastern District of Virginia case that most courts have followed to rule misclassification out of bounds of 7434. In citing Liverett, Mizelle argues that because Sec. 7434 defines “information return” as “any statement of the amount of payments [Court’s emphasis added],” the statute thus “only gives liability for” fraudulent payments and “not for any willful filing of an information return instead of a W-2.”

Further, Mizelle also finds that, because Austin herself did not have standing as an individual and because the only case before her now is from Austin Marketing, technically Austin Marketing is not a person to whom W-2s could even be issued. She also finds that the Form 1099s “properly included reimbursements for business expenses” and that “even if the law required exclusion of the reimbursed expenses,” there was no willfulness on the part of the defendants. Mizelle writes that “Austin Marketing’s evidence is…scant [and] amount to mere speculation.”

The Austin case is now one of many, that we have analyzed here, that delve into the frustrating question of whether “fraudulent” describes just payment amounts. Even so, even if one were to take a strictly textualist view of the statute, it is not entirely clear that pure misclassification is not compatible with the statute.

As I have noted here before, even a textual reading of the statute could support the notion that misclassification could give rise to a cause of action under this law. When someone is fraudulently misclassified as a 1099 worker when they should have received a W-2, they receive a form that is, in several ways, different in numbers, format, and details than what is appropriate. Notably here, if a misclassified person was hypothetically reclassified as a W-2 worker, it is possible the taxable gross wages that are reported on line 1 of the W-2 would be different than what their 1099-NEC had shown. That is because of course the taxable wages could exclude some pre-tax deductions whereas it is possible that a 1099 compensation amount wouldn’t account for that. That difference is a difference in amount and if an employer willfully, fraudulently misclassifies as a worker and such a difference is conceivable, the 1099 is arguably also fraudulent in amount.

Further, even if the gross compensation would be the same for a misclassified worker on a 1099 or W-2, the misclassified worker is missing out on federal income tax withholding. As such, the misclassified worker lacks the benefit of such a “payment,” a credit they can use on their tax return where their tax withheld is described by the IRS itself as a “payment.” Therefore, it could credibly be argued that “with respect to payments” could theoretically encompass the “payment” that a federal income tax withholding ultimately is. Judge Mizelle took a strict textualist view to find pure misclassification, when the compensation is not in dispute, to be out of scope for this statute. Another court in the future may take a different view even with the same style of statutory interpretation.

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

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.

So You Want to Raise an IRC § 7602(e) Issue…

Previously, I wrote about why it is IRC § 7602(e) wouldn’t keep the IRS from using information returns from banks to audit taxpayers. Let’s now suppose my analysis from the prior post is completely and entirely wrong and the IRS can’t use information returns in the way I suggest. What happens if the IRS still does?

“Well, they’d be violating the law,” you (and my idealistic students) say.

Yes, they would be. But what are the consequences? How would that ever come before a court? And perhaps more importantly, what remedies would individual taxpayers have that are caught up in this process?

Not much, I’d suggest. Let me explain why…

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Apologies for making you click the “read more” button and then abruptly pausing, but I think some important context needs to be laid before going further. To wit, I want to emphasize two important points:

First, I strongly believe that the IRS wouldn’t actually be violating IRC § 7602(e) by using information returns from banks in the ways they are most likely to actually use the data. At the very least, I strongly believe that the IRS would have a strong argument that they were not violating IRC § 7602(e) in most cases.

Second, I do not believe for a moment that the IRS would knowingly violate IRC § 7602(e) as a matter of policy if they believed it did constrain them vis a vis bank information returns. In other words, while individual employees might violate IRC § 7602(e), I fully trust the IRS to set official policies that would abide by the law in determining how to use any bank information returns that come their way.

I don’t make these points just to score some sympathy with the government readers of the blog. I make them because I believe them, and because they are important for understanding the substantive analysis that follows. Even when and if a wayward IRS employee were to violate IRC § 7602(e) the remedies of the taxpayer are extremely limited.

Avenues of Argument: Where to Raise IRC § 7602(e) Concerns

When Prof. Breen wrote his PT post (here) about IRC § 7602(e) he remarked that it did not appear practitioners were raising IRC § 7602(e) issues very often. Prof. Breen found only one Tax Court opinion that cross-referenced IRC § 7602(e), and that particular case found the statute inapplicable. Prof. Breen’s post was published back in October 2016. How much has changed in the past half-decade?

Not much.

There is still only one Tax Court opinion that I found referencing IRC § 7602(e) -the very one Prof. Breen referred to. However, in expanding my search to include opinions in other federal courts the number of opinions referencing IRC § 7602(e) skyrocketed to… nine. Well, eight if you want to look at separate cases. Actually, more like six if you also filter out the absolute nonsense arguments (tax protestors and family law cases).

So in 23 years we’ve had about six cases where IRC § 7602(e) has been raised and a court has given an opinion on its application. And of those six cases the court has found the IRS in violation of IRC § 7602(e)… zero times. In fact, I can’t find a single opinion where IRC § 7602(e) has played a role in yielding an IRS-averse outcome.

It should be noted here, very importantly, that this doesn’t mean that IRC § 7602(e) is meaningless. Indeed, there could be a trove of court orders (rather than opinions) where IRC § 7602(e) comes into play. Similarly, it could be that IRC § 7602(e) comes into play in administrative and behind-the-scenes posturing between the IRS and taxpayers, none of which gets reported on Westlaw. Lastly, and again importantly, IRC § 7602(e) did have a change on IRS policy.

Indeed, an optimist could say “we don’t see IRC § 7602(e) issues in court because the IRS follows it in the first place.” I’ll genuinely reserve judgment on that, since I rarely deal with financial status audits (I can think of once in my career where they’ve come up). But let’s assume we were to see a massive increase in IRC § 7602(e) violations spurred by new bank reporting requirements. How can taxpayers fight against this abuse?

As far as I can tell, there would be three likely ways to get into court and argue that the IRS’s use of bank reporting violated IRC § 7602(e): (1) moving to quash a summons, (2) deficiency proceedings, and (3) collection due process hearings. Let’s take each in turn.

Motion to Quash a Summons

The most straightforward and appropriate way to challenge a perceived IRC § 7602(e) abuse is while the IRS examination is still on-going. Unfortunately, there aren’t a lot of ways to get into a federal court (and virtually no way to get into Tax Court) before the IRS has actually determined a deficiency. However, if you stonewall the IRS requests for information in audit long enough you just might get your wish when the IRS stops playing around and issues a summons.

Indeed, bringing suit against summons appears to be the most natural way to enforce IRC § 7602(e). In the words of one court:

[We] can find no precedent indicating citizens can bring a cause of action against the United States to enforce this section [IRC § 7602(e)], and the statute itself provides no waiver of sovereign immunity. Instead, the context in which this section typically arises is a suit by the IRS to enforce a summons issued under 26 U.S.C. § 7602 or a suit by a taxpayer to quash such a summons.

Mortland v. I.R.S., 2003 WL 21791249, at *3 (W.D. Tex. June 24, 2003)

There is a fairly obvious problem with bringing a suit to quash a summons as it relates to a bank information return. Namely, that the bank information return would not be issued pursuant to a summons. Presumably, the taxpayer argument would be that the (later) summons stems from an inappropriately initiated examination -i.e. one where the IRS is using financial status audit techniques without first having a reasonable indication that you have unreported income. The problem is that the bank information return is prior to the summons and (presumably) would give the IRS exactly the “reasonable indication” it needs. Again, as I raised in my first post, contrary to the Forbes/Brookings article’s contentions, the increased bank reporting would actually reduce the scope of IRC § 7602(e) rather than the other way around.

The horse has left the barn by the time you’re trying to quash a summons based on a bank information return. You’re out of luck in challenging the legality of the information return in this venue, since the only thing at issue is the summons itself. If you want to challenge the information returns prior to the summons you are going to run into the two-headed hydra of sovereign immunity and the Anti-Injunction Act.

Furthermore, the track record of the arguments on quashing summons on IRC § 7602(e) is… not great. At least in the opinions I found. Again, there could be a million court orders out there where the summonses are indeed quashed, and which have flown under the radar of my search (which only covers opinions). But the opinions that can be found on Westlaw don’t paint an optimistic picture for taxpayers. Of the cases I reviewed, literally none of them resulted in a quashed summons and all of them supported my contention that increased bank reporting would actually neuter IRC § 7602(e) arguments.

Many of the cases raising IRC § 7602(e) arguments failed on procedural grounds such that the court didn’t even need to reach the merits. Nonetheless, the courts made a point of saying that “even if they would have” considered the merits, the taxpayers would have lost because the IRS had a reasonable indication of unreported income allowing such financial status exams in the first place. Examples for the requisite reasonable indication of unreported income included:

(1) a tip from someone to the IRS about unreported income (United States v. Abramson-Schmeiler, 2010 WL 11537887 (D. Colo. Oct. 14, 2010));

(2) previous bank records sent by the taxpayer being mysteriously incomplete (Chapin v. IRS); and

(3) tax protestors sending a letter to the IRS declaring they “removing themselves from the income tax system.” (Billheimer v. United States, 2003 WL 22284193 (S.D. Ohio July 31, 2003) It is hard to imagine that the additional information provided to the IRS by bank information reporting would make it harder for them to meet the “reasonable indication” standard.

It is hard to imagine that the additional information provided to the IRS by bank information reporting would make it harder for them to meet the “reasonable indication” standard.

I suppose one could make a long-shot argument that the IRS can’t summons for bank account records under Powell because, if the bank information returns show inflows and outflows, the IRS already has the information requested in the summons. But that argument is pretty much self-defeating. If the banks are really going to be reporting so much information that the actual bank account statements are superfluous I don’t think the IRS is going to waste time issuing summonses for the records. More likely, the information will give a “suggestion” of unreported income (again, ruining IRC § 7602(e) arguments) which could be augmented by a fuller picture of the bank accounts at issue.

The verdict? Challenging a summons isn’t the way to contest the legality of any new bank information reporting requirement. On to the next potential argument…

Raising IRC § 7602(e) Concerns in a Deficiency Proceeding

Generally speaking, if you’re raising concerns about the audit process to the Tax Court you are setting yourself up for failure. The role of the Tax Court is to determine the deficiency, which it does on a de novo review. If you’re arguing about the way you were treated in the steps leading to the notice of deficiency you will get, at absolute best, a “Sorry, but we’re a court of limited jurisdiction” response from the Tax Court. You will also likely get a citation to Greenberg’s Express.

There are, however, some instances where the processes leading to the notice of deficiency matter. And those instances just so happen to be those that involve unreported income and financial status (or “indirect proof”) methods of audit. If you can show that the IRS didn’t really do its homework in determining unreported income, you can remove the “presumption of correctness” that usually attaches to a notice of deficiency determination. Professor Camp has an excellent post on these so-called “naked assessments” which can be found here.

If all the IRS did was look at the information report from the bank and then, without anything more, said “looks like [x] amount of unreported income to me,” there could be an argument that the deficiency determination was a naked assessment unworthy of the cloak of “correctness” that it is usually clothed in. If the IRS didn’t do literally anything other than take the information return at face value, I think that would render it naked. How far of an investigation beyond “nothing at all” that the IRS would need to take, however, is debatable. Note, however, that such a determination would at least appear to violate the IRS’s understanding of IRC § 7602(e) as reflected in the memo I cited to in my previous post.

There also is a twist here, since the information return might (but might not) implicate IRC § 6201(d). There are too many unknowns as to whether the actual information returns from the bank would implicate IRC § 6201(d), both because it might not really be considered an “item of income” and because Congress could put the reporting requirements from banks somewhere other than “under subpart B or C of part III of subchapter A of chapter 61” (i.e. the returns that IRC § 6201(d) covers). However, if the information return does fall under the purview of that section, by putting the information return at issue you could shift the burden of proof to the IRS.

The verdict on arguing against bank information returns in a deficiency proceeding is… maybe. But you may have noticed that I didn’t actually use IRC § 7602(e) in any of my analysis above. That’s because I think it likely would be irrelevant to the Tax Court, even if violated. There are no cases that have found that an IRC § 7602(e) violation would ruin the presumption of correctness, or otherwise have any effect on the deficiency proceeding. I fairly doubt the Tax Court has an appetite for creating any such rule.

IRC § 7602(e) and Collection Due Process

Lastly, we have Collection Due Process jurisdiction. This is the most convoluted route to raising IRC § 7602(e) arguments, but in some ways the best venue for its success. This is because it is the only venue where you have the court empowered to review IRS conduct -something largely absent from deficiency proceedings. The IRS failing to conduct itself in accordance with the law is certainly something the Tax Court would care about in a CDP hearing. The question is how a fundamentally examination issue could ever come up in what is (typically) a collection venue.

I have strained to think of the ways in which you could raise examination issues in a CDP hearing. I have failed. The best argument I can think of is admittedly strained, but I’ll put it out there for those aspiring to make a name for themselves with creative arguments.

As part of a CDP hearing, IRS Appeals is required to verify that “the requirements of any applicable law or administrative procedure have been met.” IRC § 6330(c)(1). Might a taxpayer raise the issue that the audit leading to the deficiency (now in collection) did not meet the applicable law?

Maybe.

But even if they showed such a violation why would it matter and what could the Tax Court do? Again, we run headlong into the issue of remedy, which was the whole impetus for my writing this post. If the relief you’re asking for is the Tax Court to invalidate the assessment… well, I wish you luck. And if you’re not asking the Tax Court to invalidate the assessment, what exactly would you be asking for? A chance to argue the underlying tax anew? Unless you meet one of the Tax Court’s unduly narrow avenues for raising that issue (covered here and here, among others) I doubt they’ll create a new one not directly linked to existing statutory language. Perhaps if you do meet the requirements to raise the underlying liability you could argue for a burden shift in a similar way to the “naked assessments” argument detailed above. However, since I’m doubtful that the IRS will rely solely on bank information returns for omitted income cases, I am doubtful this tactic would get very far.

The verdict on prevailing on IRC § 7602(e) issues in CDP hearings… highly unlikely.

And so the individual taxpayer is largely without recourse when and if that code section was ever violated by the IRS using these new-fangled bank information reports. I didn’t discuss but likewise doubt that any Administrative Procedure Act style argument would prevail, though I am open to being second-guessed on that. To the extent that recent cases have chipped a bit off of the Anti-Injunction Act, I believe more than enough remains to preclude suits based solely on IRS examination tactics.

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

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.

Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?…Part IV

We welcome back guest blogger Omeed Firouzi who brings us up to date on litigation over the scope of section 7434’s cause of action for the fraudulent filing of information returns. Christine

Internal Revenue Code Section 7434 has been the subject of numerous posts here. In the aftermath of the Liverett decision in the Eastern District of Virginia in 2016, courts have largely agreed that while  intentionally wrongful overreporting of income  on an information return constitutes “fraudulent filing,” misclassification itself (actually receiving a 1099-MISC instead of a W-2 with no dispute about the income amount) is not actionable under section 7434.

Nevertheless, a small handful of federal district court decisions very recently have left the door open, at least in the preliminary stages of litigation, to the possibility that Section 7434 could encompass misclassification claims. The United States District Court for the Western District of Washington in September became the most recent court to address the matter.

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The facts in Ranko v. Gulf Maine Products Co. Inc., Et. Al. involve taxpayer William Ranko and his work for seafood processor and wholesaler Gulf Marine. Ranko filed suit in King County Superior Court but Gulf Marine removed the case to the federal district court, on the basis of diversity of citizenship. Mr. Ranko alleges several causes of action, including violations of Section 7434 and various employment-related claims.

With regard to the specific federal tax issue at hand, Mr. Ranko alleged that Gulf Marine misclassified him as an independent contractor in tax years 2016, 2017, and 2018. Mr. Ranko was referred to as an Outside Sales Manager and was treated as an employee, he alleged, yet his employer failed to withhold taxes. As a result of such misclassification, Mr. Ranko owed more federal taxes than he should have. While there is no evidence in the case that Mr. Ranko filed a Form SS-8 to challenge his misclassification before the IRS, the facts alleged do seem to support Mr. Ranko’s contention that he was an employee.

Mr. Ranko attested that such misclassification was itself a violation of Section 7434. Though Mr. Ranko separately claimed nonpayment of wages, he did not allege that the actual amounts on the 1099-MISC filed by Gulf Marine were incorrect. Rather, he alleged that the “fraudulent filing” under 7434 was the wrongful, intentional filing of 1099s rather than the W-2s that he should have received.

Interestingly, unlike several other courts that have analyzed Section 7434 at length, the court here did not engage in an extensive analysis of the Liverett decision and its interpretation of the legislative history behind Section 7434. Rather, the court focused on the intentionality of the employer’s alleged misconduct in allowing Mr. Ranko’s claim to move forward. Indeed, the court noted that “the misclassification enabled Gulf Marine to avoid tax liability by failing to ‘pay one half of the payroll taxes” and that such “allegations are sufficient to raise a reasonable inference that Gulf Marine willfully filed a fraudulent information return with respect to payments purported to have been made to” Mr. Ranko. Consequently, the court denied Gulf Marine’s motion to dismiss this cause of action.

The Ranko court appears to be part of the aforementioned trend of district courts that have refused to dismiss outright the possibility that misclassification on its own is actionable under Section 7434. Part of how the Ranko court got here too relied on the Greenwald v. Regency Mgmt. Servs., LLC decision in the U.S. District Court for the District of Maryland in 2019.

The Greenwald case was brought by Maryland employment attorney Richard Neuworth (who I’ve incidentally had the privilege of getting to know at various ABA Tax Section conferences and who has been a resource on misclassification work) as he has sought to protect wronged employees in such cases. In Greenwald, the workers alleged that their information returns did not include commissions (on which taxes were not withheld) that they received after their employment ended, and so those information returns constituted “fraudulent filing.” The court there agreed there were sufficient grounds for a claim under 7434. But the Ranko court here appears to be going even further in stating that even when there is no dispute at all about the dollar amount reported on the information return, there can be a 7434 claim.

The Ranko court may be helping to break new ground here. Then again, the District of New Jersey recently again ruled the other way on this matter. Ultimately, as discussed extensively on this blog, the issue is one of statutory interpretation. Whether “fraudulent” is an adjective that describes the filing in a broad sense or whether “fraudulent” only relates to “payments” will continue to vex courts for some time to come, absent congressional action. Notably though, the statutory text at Section 7434(a) does not include the words “amount,” “compensation” or “income.”

Rather, the statute states the willful filing must be “with respect to payments purported to be made.” The Ranko court appears to be construing the statute broadly to understand that the phrase, “payments purported to be made,” encompasses any payments and fraud that is present with respect to such payments. In other words, fraud “with respect to [the] payments” is not limited solely to fraud in the amount of the payment reported.

Instead, the argument is that the payments should have been reported or handled differently. This could encompass different specific acts, but the Ranko court is clearly concerned that the employer’s treatment and reporting of the payments as non-employee compensation burdens the employee with taxes they should not owe. This is not only due to the lack of withholding but also simply due to the different FICA/Medicare tax burdens on employees versus non-employees. Should the case move further along, it will be fascinating to see whether the court will find that it was Congress’ intent to protect such individuals from employer misconduct.

Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?

In today’s post, guest blogger Omeed Firouzi discusses the availability of civil damages for misclassified workers who receive inaccurate information returns from their employer. Christine

One of the most intriguing issues in tax law involves the interpretation of 26 U.S.C. Section 7434. As discussed extensively in various posts here, Section 7434 clearly encompasses situations in which taxpayers are issued income-reporting information returns that intentionally misstate the amount of their income. It is less clear if Section 7434 applies to situations in which a taxpayer is given the wrong kind of information return even if the amount of income is correct. Most courts that have ruled on this issue have found that a taxpayer who is misclassified as an independent contractor – and thus receives a Form 1099-MISC rather than a Form W-2 – does not have a cause of action under Section 7434.

These courts have largely followed the lead of the Liverett court, where the United States District Court for the Eastern District of Virginia undertook a thorough analysis of the statutory language and the legislative history of the law and found that it does not encompass pure misclassification. No circuit court has ruled on the issue but a consensus in the lower courts has emerged. The United States District Court for the District of Maryland recently also followed the lead of Liverett in Alan Wagner v. Economy Rent-A-Car Corp., et al.

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Wagner involves a Maryland taxpayer who filed suit under various Maryland employment-related statutes and Section 7434 as he alleged willful misclassification through the fraudulent reporting of payments on a 1099 instead of a W-2. In November 2013, the taxpayer initially signed a contract that agreed to “a fixed monthly salary of $5,000 per month plus commission…based on the value of contracts [he] procured for” the company. Ultimately, the taxpayer became a “full-time…employee” and received a W-2 for several consecutive tax years.

Then in 2016, the taxpayer alleges that his employer “began to pressure” him to accept 1099 classification and “when [he] refused, it is alleged that [the employer] began to withhold his commission payments.” The two parties subsequently entered into a “separation agreement” pursuant to which the taxpayer’s employer agreed to pay him “a ‘net’ sum of $45,000 in three installments ‘in exchange for a non-solicitation agreement.’” These payments were issued on a Form 1099 rather than on a W-2.

However, yet again, the court joined the growing consensus in rejecting the notion that Section 7434 applies here.  The court noted that Section 7434 “creates a private cause of action only where an information return is fraudulent with respect to the amount purportedly paid to the plaintiff.” The court also held that “the first rule of Liverett [is that] … plaintiffs cannot prevail under § 7434 by merely alleging that they have been misclassified as independent contractors, or received the wrong type of information return.”

The court recognized that Greenwald v. Regency Mgmt. Servs., LLC, 372 F. Supp. 3d 266, 270 (D. Md. 2019) carved out an exception such that “if the misclassification causes the underreporting of paid wages,” there may be a 7434 cause of action. The case was distinguishable from Greenwald though in that there was no misstatement in the amount of income in question the taxpayer received; the receipt of the aforementioned $45,000 was never in dispute. The proper classification of this income was the central tenet of the taxpayer’s 7434 claim. Consequently, the court found that “on its face, this is a ‘misclassification’ claim which cannot support a § 7434 action.” As such, the claim was dismissed.

The complexity here lies in the modifiers within 7434, as Stephen Olsen has previously described here. A “fraudulent information return with respect to payments purported to be made” clearly applies to reported compensation but when taxpayers are issued 1099s instead of W-2s, the amounts on those information returns will be different anyway. W-2s include withholding and deductions which typically do not appear on Forms 1099-MISC. If an employer willfully misclassifies a taxpayer as an independent contractor and the employer intentionally disregards obligations to withhold Social Security and Medicare taxes, is that information return not, per se, “fraudulent…with respect to payments”?

Further, that the term “fraudulent” comes before “information return” suggests that the type of information return itself, not just the amount, is relevant. This adjective-based analysis might seem overly simplistic but pre-Liverett case law – which is still good law – made it clear in a straightforward manner. For instance, the U.S. District Court for the Southern District of Florida found in a pair of misclassification cases that that “to establish a claim of tax fraud under 26 U.S.C. Section 7434,” one of the necessary elements was simply that the “information return was fraudulent.” In both Seijo v. Casa Salsa, 2013 WL 6184969 (SD Fla. 2013) and Leon v. Taps & Tintos, Inc., 51 F.Supp.3d 1290 (SD Fla. 2014), the willful issuance of a 1099 rather than a W-2 was sufficient proof for this prong of the claim. Strikingly, the Seijo court found that because a 1099 is a “form used to record payments made to an independent contracto[r] and [the worker] was not an independent contractor,” the intentional misclassification was actionable. It cited Pitcher v. Waldman, 2012 WL 5269060, at *4 (S.D. Ohio 2012) for support of the proposition that even if the “amount of the payment [is] not in dispute…[if] the form used to report that payment and the tax implications that went along with that form” are at issue, there could be a claim.

The specter of the “tax implications” that result from misclassification challenge a Liverett-based analysis like the one the Wagner court adopted. Liverett cited the legislative history of 7434 in that it noted how Congress was concerned with “malcontents who ‘sometimes file fraudulent information returns reporting large amount of income for judges, law enforcement officers, and others who have incurred their wrath.” The tax implications though that arise from such efforts are as similarly harmful for workers as misclassification itself. When a taxpayer is issued an information return that overstates their income, it creates additional, unwarranted tax burdens for them. When a taxpayer is issued an information return that is correct in income amount but wrong in the type of return because they were misclassified, it also creates an additional, unwarranted burden.

Congress was concerned with “significant personal loss and inconvenience” for taxpayers as a “result of the IRS receiving fraudulent information returns.” When taxpayers are willfully misclassified as independent contractors, they lose out on myriad benefits employees enjoy under various laws and they are saddled with a self-employment tax that can be onerous for low-income workers. Though the specific examples described in the legislative history do not exactly mirror misclassification cases, they provide a useful window into the broader purpose of the statute: the protection of taxpayers from fraudulent actors who create unnecessary burdens for them. Misclassification is such a burden. Further, one canon of statutory interpretation that was not advanced in Wagner but could arise in a future 7434 case is the notion that if Congress wanted to explicitly clarify that 7434 applied strictly to amounts, it could have done so in the intervening years. Since the law’s enactment in 1996, various, sweeping tax laws have passed under four presidents and misclassification has only grown as a problem in the meantime. Nevertheless, Congress has not amended 7434 to provide more clarity here. Considering the increasingly salient issue of misclassification, it may be that Congress will soon reexamine this vexing statute.

Working Through an Employer’s Failure to File Form W-2 or 1099 with the IRS

We welcome guest blogger Omeed Firouzi to PT. Omeed is a Christine A. Brunswick public service fellow with Philadelphia Legal Assistance’s low-income taxpayer clinic, and he is an alum of the Villanova Law Clinical Program. His fellowship project focuses on worker classification. In this post, Omeed examines a recent case where the taxpayer unsuccessfully sought relief under section 7434 for her employer’s failure to report her compensation to the government at all. Litigation in this area is likely to continue. Christine

Tax season is upon us so I would be remiss if I did not cite fellow Philadelphian Ben Franklin’s famous maxim that “in this world nothing can be said to be certain, except death and taxes.” But whether you are filing your return as soon as possible or at 11:59 PM on April 15, there is one thing that is uncertain for many taxpayers: whether your employer filed an information return.

As we have seen in our clinic at Philadelphia Legal Assistance and more broadly, employers are increasingly not filing income reporting information returns with the Social Security Administration (SSA) and the Internal Revenue Service (IRS). The Internal Revenue Manual, at IRM 21.3.6.4.7.1, describes the proper procedure for IRS employees to follow should a taxpayer not receive an information return. The IRS website also provides tips and tools for how taxpayers should proceed in such situations.

Under the Internal Revenue Code and regulations promulgated under the Code, employers could be held liable – and subject to penalties – for failure to file correct information returns. However, the IRC and its accompanying regulations lack a clearly defined legal recourse for individual taxpayers when the employer fails to file any information return at all. No explicit cause of action exists for workers in this predicament. Recently, a taxpayer in New York unsuccessfully tried to make the case that 26 U.S.C. Section 7434 encompasses this situation.

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The statute states, in part:

If any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, such other person may bring a civil action for damages against the person so filing such return.

This statute has been the subject of several previous Procedurally Taxing posts. As these posts described in detail, courts are in consensus that the statute at least encompasses an employer’s willful misstatement on an information return of the amount of money paid to a worker. The legislative history of Section 7434 reveals that when Congress drafted the legislation in 1996, its authors were concerned with the prospect of “taxpayers suffer[ing] significant personal loss and inconvenience as the result of the IRS receiving fraudulent information returns, which have been filed by persons intent on either defrauding the IRS or harassing taxpayers.” 

The case law is split on whether misclassified taxpayers can use Section 7434 to file suit against their employers for fraudulently filing a 1099-MISC rather than a W-2, if the dollar amount reported is correct. No circuit court has ruled on the issue but most courts have followed the lead of the U.S. District Court for the Eastern District of Virginia and its Liverett decision that found that Section 7434 does not apply to misclassification.

However, one aspect of Section 7434 where there is judicial consensus is that the statute does not encompass the non-filing of an information return.

The U.S. District Court for the Eastern District of New York recently joined the chorus of courts on this issue. In Francisco v. Nytex Care, Inc., the aforementioned New York taxpayer argued that her former employer, NYTex Care, Inc., violated Section 7434 by “failing to report payments made” to the taxpayer and other workers. The facts of the case are straightforward. Taxpayer Herlinda Francisco alleged NYTex Care, a dry cleaning business, “fail[ed] to identify [her] and other employees as employees” by failing to file information returns for tax years 2010, 2011, 2012, 2013, 2014, 2015, and 2016. Francisco filed suit under Section 7434 alleging that NYTex “willfully and fraudulently filed false returns…by failing to report” employees’ income.

The court principally cited Second Circuit precedent, set in Katzman v. Essex Waterfront Owners LLC, 660 F.3d 565 [108 AFTR 2d 2011-7039] (2d Cir. 2011) (per curiam), in dismissing the case. Katzman established that Section 7434 “plainly does not encompass an alleged failure to file a required information return.” In Nytex, the employer “did not report payments made” to the taxpayer and other employees but the court found that Section 7434 was not the appropriate remedy.

More broadly, the Nytex court examined the plain language of Section 7434, its legislative history, and other relevant case law in foreclosing this claim. The plain text of the statute, the court noted, necessitates a filing by definition; there must be a filed information return in order for it to be fraudulent. The court also looked to Katzman’s parsing of congressional intent for guidance; in Katzman, the Second Circuit ruled explicitly that “nothing in the legislative history suggests that Congress wished to extend the private right of action it created to circumstances where the defendant allegedly failed to file an information return.”

Further, the court even relied upon another case the same plaintiffs’ attorney brought in the Southern District of New York. In Pacheco v. Chickpea at 14th Street, Inc., the plaintiff there also brought suit under Section 7434 on the basis of the failure of their employer to file information returns but the Southern District “found [that situation] was not covered by the statute.” Ultimately, the Nytex court granted the Defendants’ motion to dismiss for failure to state a claim upon which relief can be granted because the court found no cognizable claim for alleged failure to file an information return under Section 7434.

The result in Nytex leaves it frustratingly unclear what remedies exist for workers who find themselves in this taxpayer’s predicament. Had the employer here actually filed a 1099-MISC with the IRS, a potential argument could’ve been made about misclassification and whether that is encompassed by Section 7434. There is more division in the courts about that issue as opposed to the question posed in Nytex. Had the employer willfully overstated the amount the taxpayer was paid, the court could’ve found a clear Section 7434 violation, based on the reporting of a fraudulent amount.

Of course, neither of those things happened here. Instead, there is an aggrieved taxpayer ultimately unable to rely on a statute that is both ambiguous and seemingly limiting all at once. Practically, she is left with no clear way to sort out her own tax filing obligations when no information returns were filed. The court interestingly does not identify an alternative course of action, or judicial remedy, the taxpayer could seek.

In relying on congressional intent, the court leaves the reader wondering if Congress ever envisioned that an employer’s failure to file an information return could cause “significant personal loss and inconvenience” to the worker. If it means a frozen refund check as part of an IRS examination, there is certainly loss and inconvenience there. As Stephen Olsen described at length previously, courts have deeply examined the statutory language in terms of whether the phrase “with respect to payments made” only modifies “fraudulent” or if the information return itself could be fraudulent even if the payment amount is correct.

That discussion raises an interesting question as it relates to Nytex: if a court found an actionable claim for non-filing under section 7434, how would it determine whether the failure to file was fraudulent or whether there was willfulness in the non-filing? Since there would be no information return, would the court be forced to look at what kind of regular pay the taxpayer got to ascertain what the information return likely would’ve been?

Then, the court would have to find that there was “willfulness” on the part of the employer, not merely an inadvertent oversight. To make matters more complex, the court would have to likely wrestle with how there could be a willful act in a case where the employer did not even act at all. If a court found willfulness, a potential argument could be that a non-filing is analogous to filing an information return with all zeroes on it thus leading the court to say it is, in effect, fraudulent in the amount.

For now though: what can a taxpayer do in such a situation? When employers fail to provide or file information returns, the IRS recommends that workers attempt to get information returns from their employers. If that fails, the IRS advises workers to request letters on their employer’s letterhead describing the pay and withholding. Should an employer not comply with these requests, the IRS can seek this information from an employer while taxpayers can file Substitute W-2s attaching other proof of income and withholding – such as bank statements, paychecks, and paystubs. If a taxpayer got an information return but the employer never filed it with the government, that might ease the burden on the taxpayer but the IRS will still seek additional verification.

Even then, taxpayers could get mired in lengthy audits and examinations all while waiting for a critical refund check they rely on to make ends meet every year. We have seen this pattern play out in our own clinic and I suspect as it befalls more taxpayers, there may be either a congressional or judicial reexamination of Section 7434 or another effort to address the problem of non-filing of information returns.

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 3)

We welcome back Megan Brackney for part three in her three-part series discussing penalties imposed on foreign information returns.  Today, she brings of stories of clients who have faced these penalties demonstrating the problems caused by the manner in which the penalties are being imposed and she brings suggestions of how to improve the system.  Keith

The Gifts That Keep on Giving

Two young people moved to the U.S. as students.  They met in graduate school and married.  After graduation, they were offered jobs and were sponsored by their employers so that they could stay in the U.S.  While they were students, their parents from their home country sent them money to help pay for their expenses in the U.S.  After they became U.S. taxpayers, they received a few more gifts, totaling more than $100,000.  They told their CPA about these gifts, and even showed him copies of their bank statements so that he could see the wire transfers from their parents’ non-U.S. accounts.  The CPA told them that because these were gifts and not subject to taxation, they did not need to be reported.  The CPA did not advise them of the Form 3520 filing requirement for gifts from foreign persons that exceed $100,000 in the aggregate during the tax year.  Neither of the taxpayers had any knowledge of the Form 3520, and genuinely believed that they were filing their returns correctly.

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A few years later, the taxpayers switched to a new CPA and again mentioned the gift issue, and she told them that they should have been filing Forms 3520 after they became U.S. taxpayers.  She prepared three Forms 3520 with statements explaining their reasonable cause, and the taxpayers filed them.  There was no audit or inquiry by the IRS and no tax due as a result of the error, and other than this understandable omission, they have a perfect compliance history.  The CPA was not aware of the Delinquent International Information Return Submission Procedures, but the taxpayers’ submission nevertheless substantially complied with the requirements for that procedure. 

Soon after their good faith attempt to self-correct, the IRS assessed the maximum amount of penalties on both taxpayers pursuant to I.R.C. § 6039F – 25% of the amount of the gifts they had received.  The IRS issued separate notices for the three years so that there were three different deadlines for the appeals, and thus three separate appeals.       

These notices were entitled “Notice of Penalty Charge.”  The Notices stated merely that “you have been charged a penalty under Section 6039F of the Internal Revenue Code for Failure to File Form 3520 to Report Receipt of Certain Gifts” and did not provide any other information or explanation.  As the word “charge” does not appear in the Code or Regulations, a lay person would not know from this notice whether there has actually been an assessment of the penalty. 

The only information provided about how to challenge the penalty was to state that the taxpayer could submit a written request for appeal within 30 days from the date of the notice which, “should reflect all facts that you contend are reasonable cause for not asserting this penalty.” 

The notice does not contain any information about collection while the appeal is pending but contains the following statement: “If you do not wish to appeal this penalty, there is nothing you need to do at this time.  You may later dispute the penalty by paying the penalty and then filing a claim.”  A reasonable layperson could interpret this to mean that the taxpayer does not have to pay the penalty until after his or her appeal.  And, indeed, as noted in the previous column, Internal Revenue Manual 8.11.5.1 states that taxpayers are afforded pre-payment appeals.  The notice does not explain any of this, however, and yet the IRS will only suspend collection activity if the taxpayer separately notifies Collections that he or she has filed an appeal (and frequently not even then).

Moreover, from the notice, there is no indication that the IRS obtained managerial approval of the penalty, as is required by I.R.C. § 6751(b), and no indication that the IRS considered the reasonable cause defense submitted along with the Forms 3520. 

The taxpayers timely submitted an appeal to each penalty, explaining again that they had reasonable cause for failure to file foreign information returns, i.e., that that they retained a competent CPA to prepare their returns, that they gave him full and complete information, and they reasonably relied on his advice that nothing needed to be done to report the gifts from their parents.

Despite the timely appeals, the IRS has continued sending collection notices.  In response to Notice CP504, the taxpayers requested that the IRS place a hold on collection pending the appeal.  The IRS did not respond, but moved forward with issuing the notice of intent to levy on one tax year.  The taxpayers were forced to file a CDP request to prevent enforced collection while Appeals considers their reasonable cause defense.  The taxpayers are frightened that the IRS will file a notice of federal tax lien, which would be devastating as they are trying to buy a house right now.  

In the meantime, for one of the tax years, the IRS sent the taxpayers a notice stating that it was rerouting the taxpayers’ correspondence (the timely filed appeal) to the Frivolous Correspondence Department.  The taxpayers promptly responded with a letter explaining that their appeal was not frivolous, and that they had a right to Appeals review, and that the IRS cannot refuse to forward their protest to Appeals.  They have received no further communications regarding the appeal. 

For another tax year, the taxpayers received a cryptic letter from the Service Center, responding to their correspondence (with the same date as the appeal for that year), by stating “We reviewed the information you provided and determined that no action is necessary on your account.”      

The taxpayers have not received any further communications from Appeals.  We have tried to find someone at the IRS who has this file, but have had no luck.  Although the Service Center told me that their case is assigned to the field, no one at that office has specific responsibility over it.  As of the date of publication of this column, the taxpayers have been waiting for over a year for an Appeals conference.  Meanwhile, the IRS collection machinery rolls on, without regard to the fact that the taxpayers have never had any Appeals review of the assessments. 

Welcome to the Machine

This taxpayer is a non-U.S. Person who is the sole shareholder of several U.S. real estate holding companies.  Due to some serious health issues, including dementia and loss of hearing, he fell behind on filing returns.  His son began taking over the business, discovered that returns had not been filed, and starting filing Forms 1120, which included Forms 5472, and a reasonable cause statement explaining his father’s health problems and his inability to file returns on time.  The entities filed the Forms 5472 for years which there was no tax due and owing pursuant to the Delinquent International Information Return Submission Procedures.  For the years in which tax was due, the entities filed the returns in the ordinary course but attached reasonable cause statements.

The IRS’s response to these various filings has been haphazard.  For many of the Forms 5472, no penalties were imposed at all.  There is no discernible pattern – sometimes tax was due, sometimes it was not; sometimes the year at issue was the first year of correction, sometimes it was a later year.  The taxpayers have no complaints about not getting penalties on these years, but it does make one wonder whether the IRS just failed to catch them, or if someone evaluated the reasonable cause defense and agreed that penalties would not be appropriate, and if this is the case, why penalties were imposed for other tax years with identical facts.

For the rest of the Forms 5472, the IRS sent out notices assessing penalties for $10,000 per form for each of late-filed Forms 5472.  The Tax Cuts and Jobs Act of 2017 (“TCJA”) increased this penalty to $25,000 for each late-filed or incomplete Form 5472.  On almost all of the notices, the tax year was mistakenly stated.  The entities are fiscal year taxpayers, with their tax years ending on different dates, such as June 30, or September 31.  The U.S. companies’ fiscal year, was, of course, stated on the front of the Forms 1120, and thus that information was available to the IRS.  However, the IRS identified the penalty period for all years as ending on December 31.

In any event, the notices of penalty were on a different form than those issued to the taxpayers described above.  These notices had a heading stating, “We Charged You A Penalty.”  This notice provided thirty days to notify the IRS if “you don’t agree with the penalty assessment,” and provided instructions on presenting a reasonable cause statement under penalties of perjury.  The notice does not explain whether this submission would be an appeal or a request for abatement.  Like the notice to the other taxpayers, this notice does not provide any information about collection or indicate whether managerial approval has been obtained or acknowledge that the taxpayer had already submitted a statement of reasonable cause under penalty of perjury.  And again, there is no concept of a “charge” under the Internal Revenue Code, and it would not be clear to a lay person trying to interpret this notice what this meant. 

In response to these notices, the entities requested abatement of penalties on the ground of reasonable cause, and the IRS granted several of these requests, with no explanation.  It is possible that for some of these penalties, the IRS was applying a concept of First Time Abatement, since they were the first tax years with non-compliance.  The First Time Abatement provisions of the Internal Revenue Manual do not refer to foreign information return penalties, but I suspect that this relief may have been granted for these entities, and I have heard, anecdotally, from other practitioners, that their clients have received this relief. 

For the penalties on which the IRS denied the request for abatement, the IRS provided an explanation for the denial and obtained proper managerial approval under I.R.C. § 6751(b).  In the letter denying the abatements, the IRS stated that the taxpayer could appeal the decision.  It is unclear why these taxpayers were provided with a two-step procedure – request abatement, and then appeal of the denial of the abatement request — while the taxpayers described above were told to go directly to Appeals.  In any event, the IRS provided these entities with 60 days in which to submit an appeal, and the entities have done so, but several months later, they still have not heard from Appeals.

In the meantime, on all of the remaining penalties, the IRS has sent collection notices, and each time, the entity responded with a request a hold on collection pending its appeal.  The IRS did not directly respond to any of this correspondence, but for some of the entities, the IRS seems to have stopped sending notices.  For other entities, the IRS issued final notices of intent to levy.  Despite already having one appeal pending, these entities were forced to submit CDP requests to avoid levy. 

In addition, for several of the penalty assessments, the IRS filed notices of federal tax lien.  As noted, the Code section that authorizes the penalty for failure to file the Form 5472 is I.R.C. § 6038A.  However, on several of the notices, the IRS stated that the penalty had been assessed under I.R.C. § 6038.  This is close, but not quite right – this is the penalty for failure to file Form 5471.  On one of the notices of federal tax lien, the IRS did not even get close, but identified the penalty as being assessed pursuant to I.R.C. § 6721 (trust fund recovery penalties).  And, as noted above, the IRS assessed the penalties for tax years ending December 31, even though the entities’ tax years do not end on December 31, but at the close of their fiscal year.  As these notices were improper and inaccurate, and the taxpayer’s Appeals had not been heard, the entities had to file CDP requests challenging the federal tax lien filings. 

The entities have not received any response to their appeals, many of which have been pending for more than a year.

Perfection is the Enemy of Good

The next taxpayer is a high net worth individual who is the grantor of a foreign trust with significant assets.  Since the formation of the trust, he has always timely filed Forms 3520 and Forms 3520-A and reported all income related to the trust.  At some point, the country codes stating where the trust was administered and what law applied were not included on the Form 3520, although that information is included in other parts of the form.  The IRS caught this error on the Form 3520 for one year and assessed a multimillion-dollar penalty pursuant to I.R.C. § 6677.  There was no tax non-compliance related to this error – it was a minor and inconsequential technical error on a timely filed return.  The taxpayer did not notice this minor error during his review of his returns and he certainly did not instruct his CPA not to fill out these items on the form.  Other than this minor foot-fault, the taxpayer has an excellent compliance history.

The notice was entitled “Notice of Penalty” charge, and provided for 30 days to appeal or request abatement and directed the taxpayer to correct the errors within 90 days or be subjected to additional penalties.  The language of the notice was unclear as to whether the taxpayer would be able to appeal if the request for abatement was denied.  To be on the safe side, the taxpayer submitted an appeal to the IRS explaining that the taxpayer had reasonable cause for the error based on reliance on his CPA, and that penalties were not appropriate because he substantially complied with the Form 3520 filing requirement. 

There is no indication from the notice that the IRS obtained managerial approval under I.R.C. § 6751, and the notice did not provide any information about suspending collection.  Before the 30-day deadline for the appeal, the IRS sent Notice CP504, taking the first steps toward enforced collection action, despite the fact that the taxpayer’s time to appeal had not yet elapsed.  The Appeal is pending, unless the IRS changes its practices, despite the timely appeal, which should be successful, the taxpayer may have a federal tax lien filed against him and may receive a notice of intent to levy and be forced to submit a second appeal through CDP.    

Suggestions for Improving Penalty Enforcement Procedures

Below are a few simple suggestions for the IRS that would go a long way toward fair and efficient administration of the Internal Revenue Code penalty provisions.

1.          Stop systematically assessing these penalties.  These are significant penalties and it is important that they only be assessed in appropriate cases.   

2.         Consider that a taxpayer voluntarily self-corrected.  Instead of encouraging voluntary compliance, the IRS is severely penalizing taxpayers without any proper purpose.  The message that the IRS is sending to taxpayers is not to attempt to resolve issues voluntarily and self-correct, as the IRS treats taxpayers who come forward to correct past non-compliance in the same manner – as harshly as possible – as those whom the IRS identifies as non-compliant. 

3.         Apply concepts of substantial compliance.  Missing a line on a form should not warrant the highest level of penalty assessment where there is no tax due or other harm to the government.

4.         Formally adopt a First Time Abatement policy for foreign information return penalties that is applied consistently among taxpayers. 

5.         Find a way to follow the Internal Revenue Manual.  Wait until the time has elapsed for filing an appeal before commencing collection action, and upon receipt of the appeal, immediately stop collection.  If there is no system in place to cause this to happen automatically, create one, or, at a minimum, add a line to the notice telling the taxpayer that if they receive a collection notice, they should notify the office that sent the notice that they have timely filed an appeal of the penalty.  Then, instruct Collections to suspend collection activity once they receive notification that an appeal has been filed.

6.         Train IRS personnel in the Service Center and Collection about these penalties, so that they know what they are and how the procedures are different than those that may apply to the usual situations they see with taxpayers who have income tax liabilities so that they are able to respond to taxpayers who call for assistance. 

7.         Use consistent language in the penalty notices.  There is no reason for there to be different versions of the notices that taxpayers receive when foreign information penalties are assessed. 

8.         Use language that tracks the statute.  There is no such thing as a penalty “charge” in the Internal Revenue Code or Treasury Regulations.  It is an assessment, and it is misleading to call it something else.

9.         Clearly describe how the taxpayers may submit their reasonable cause defenses to the IRS, and state that if the IRS denies abatement, they may request an appeal.

10.       Notify taxpayers that they can request additional time to appeal and explain the process for doing so, or provide a longer time period and make it consistent for all taxpayers. 

At this point, there have been very few court decisions addressing reasonable cause and other defenses to foreign information return penalties, and none addressing the IRS’s procedures.  This may be because the increase in systematic assessments is fairly recent, and it also may be because for Forms 5471, 8938, and Forms 5472 (until the TCJA increased it), the penalty of $10,000 per form did not warrant the cost of federal litigation.  The IRS should not take advantage of the fact that most people will not go to court to challenge these penalties, but should take immediate action to ensure that they are being applied in an appropriate manner, and that taxpayer’s right to challenge the IRS’s position and be heard, the right to appeal an IRS decision in an independent forum, and the right to a fair and just tax system are being honored and protected.  As can be seen by the cases discussed in today’s post, the IRS is not taking steps to protect these rights.